This is what the stock exchange used to look like: a large room, screens on the walls displaying constantly changing columns of numbers, a hectic crowd of people on the floor. But the picture has changed: the screens are still there, but the crowd has become much smaller, replaced by computers. The traders who are responsible for the computers and control them are sitting at home or in the office. What was previously traded within days, hours, minutes e.g. Binary Options is now bought and sold within seconds, milliseconds, microseconds. High-frequency trading makes up only a very small proportion of trades overall, but moves about two-thirds of all stock market trades.
What is high-frequency trading?
High-frequency trading is a system in which software programs and algorithms make multiple trades per second, creating an advantage over “normal” trading. The basic idea being to execute trades as quickly as possible, which is why in some cases even a fraction of a second can cause a profitable trade to turn into a loss. Accordingly, special strategies have evolved over time that high frequency traders use to gain a competitive advantage.
How does high-frequency trading make money?
Initially the basic strategy of high-frequency traders is very simple: trade as much and as fast as possible. The profit on each individual trade is often very small, but through mass and speed, the small amounts add up to millions. For this to work, high-frequency trading programs must always be a fraction of a second faster than everyone else. And this is only possible if they are as close as possible to the stock exchange – the shorter the cable, the faster the information transfer – it’s all about milliseconds. An example : the buy price for a stock increases minimally. Since the high frequency trading programs can process this information before the other trading programs, they have the opportunity to be the first to react to the price trend. Before the trend comes to an end, the equity securities are sold again – with minimal profit per security.
The Pros of High-Frequency Trading
In addition to the advantages for users of high frequency trading there are other benefits:
- Increase of stability and liquidity
- Facilitates pricing and reduces price volatility
Increase of stability and liquidity
Many market researchers believe that high-frequency trading increases the stability and liquidity of the market. A market has high liquidity when there is a trading partner for every offer. However, high-frequency traders mainly enter markets that are already very liquid anyway. Moreover, they are not obliged to always be available as trading partners. When they are most needed in a crisis, high-frequency traders withdraw from the market and the advantage expires.
Facilitates Pricing and Reduces Price Volatility
It is believed that high-frequency trading facilitates pricing and reduces price volatility. However, these statements are also highly controversial, as some mechanisms of high-frequency trading result in opposite effects.
The Cons of High-Frequency Trading
One should also consider the cons of high-frequency trading:
- Ordinary traders cannot keep up
- Manipulation and exploitation
- Technical hazards
Ordinary Traders Cannot Keep Up
Among the disadvantages is that ordinary traders cannot keep up with the high-frequency traders’ speed race, because not everyone can afford the rents for the pitches close to the exchange. Furthermore, they cannot pay for the custom-built high-frequency trading algorithms. Because of their more direct proximity to the exchange, high-frequency traders do have a clear information advantage. This means that all classical traders are inferior to high-frequency traders.
Manipulation and Exploitation
The novel high speed and lack of regulation are often exploited by high frequency traders to manipulate the markets and deceive other market participants. For example, it is difficult and costly to stay one step ahead of yourself. Whereas, it is easy to slow down all other market participants. This can be done by “Quote Stuffing”. A trading program makes thousands of small, unimportant offers, this way generating a flood of information. When filtering out this unimportant information, the other programs lose valuable milliseconds and react too late to the interesting offers.
Computerized high-speed trading also creates technical hazards. Even the programmers of the trading algorithms themselves say that they can no longer understand everything the programs do due to the extreme complexity of the algorithms and the stock market environment. Moreover, these are of course never completely error-free.
Conclusion – High Speed, High Risk
Trading has experienced some major changes. The high-frequency trading algorithm is a perfect example of this transformation of financial markets, making them incredibly speedy. However, with the increase in speed, there’s also an increase in risk.