What is high-frequency trading and should you choose it?

High Frequency Trading (HFT) has become an integral part of today's financial markets. This form of trading has brought the markets into the age of technology and digitalisation, changing them beyond recognition. We will look at exactly how HFT works and what benefits and risks it brings with it. We will also explain why the practice is so controversial and the challenges it poses to market participants.

What is high frequency trading?

High-frequency trading is a strategy that is actively used by hedge funds and large banks. It is based on powerful computers similar to those used on leading financial exchanges such as Euronext and NYSE. These machines simultaneously analyse data from dozens of financial markets and process millions of orders in a fraction of a second. This speed allows traders to anticipate changes in market trends much earlier than ordinary investors can. In just milliseconds, these computers are able to change strategies and adjust orders.

However, high-frequency trading also makes markets much more volatile, contributing to sharp price swings. The algorithms used in HFT analyse market conditions and can instantly cancel or place millions of orders until a price is reached that most investors are happy with. Once this level is reached, the computers start selling stocks en masse, which can dramatically change the market trend.

Disadvantages of high-frequency trading

We all remember the Flash Crash, an event that occurred on 6 May 2010 when the Dow Jones Industrial Average suddenly collapsed 998.52 points in less than 45 minutes before partially recovering by 600 points. That precipitous 9.2 per cent drop in just 10 minutes was the largest in the history of the financial markets. At the time, high-frequency trading was mentioned among the possible causes of this crash. Since then, the term ‘Flash Crash’ has come to be used to describe instantaneous stock market crashes that last only a few seconds or minutes.

While many reports have since ruled out high-frequency trading as a direct cause of the 6 May 2010 incident, the issue of liquidity and risk associated with financial markets remains relevant. Without reliable price data, it is clear that HFT operations can carry significant risks and pose potential threats to market stability.

Framework for High Frequency Trading

Senator Charles Schumer, Chairman of the US Senate Committee on Legislation and Administration, is one of the main opponents of high-frequency trading. Since 2009, he has been asking the SEC (Securities and Exchange Commission) to ban flash orders used in high-frequency trading. In his letter to the SEC chairman, Senator Schumer threatens to resort to legislative action if he fails to ban these orders, which he believes undermine the integrity of the markets and disadvantage small investors.

In the process of transposing MiFID 2, the second version of the Markets in Financial Instruments Directive, the European Commission has published a number of rules and definitions, including the long-awaited one relating to HFTs. From 2018, trading firms sending ‘four messages across multiple instruments and on the same platform’ or ‘at least two messages (quotes, orders, confirmations, quote cancellations, etc.) per second across multiple instruments and on the same platform’ will be considered as companies practising this type of trading. HFTs will also be required to store their algorithms for five years and provide detailed data on their trades.

AMF study on the impact of high-frequency trading on markets

In January 2017, AMF published a study on the behaviour of high-frequency traders between November 2015 and July 2016. It notes that the beginning of 2016 was characterised by high volatility, doubts about the Chinese economy and June was marked by uncertainty surrounding the UK referendum. AMF notes that ‘when the market finds itself in such a configuration, it tends to have serious liquidity implications.’

At the same time, trading volumes rise and market makers' risk increases, forcing them to proportionately limit their presence on the order book. The study shows that high-frequency traders play an important role in maintaining liquidity. ‘At the best limit, they are present more than 90 per cent of the time.’ The study notes that ‘they occupy an average of 80 per cent of the quantity observed at the three best limits of the order book’ and points out that ‘these players help to reduce spreads early in the day by gradually entering the order book, but exit significantly before the announcement of data that could impact prices.’

AMF points out that high-frequency traders on average consume more liquidity than they provide, especially during periods of heightened volatility. It goes on to say that ‘general market stress always results in lower quantities offered at the best limits for all market participants and has a negative impact on liquidity.’ Finally, the AMF study points to ‘an increased presence of high-frequency traders during localised periods of severe stress’.

Conclusion

High-frequency trading continues to be one of the most advanced and controversial strategies in the financial markets. It has changed the rules of the game by providing traders and large financial institutions with powerful tools to respond quickly to the smallest price fluctuations. Before deciding to implement high-frequency strategies, it is important to carefully weigh the pros and cons, considering both the potential benefits and risks. HFT can be useful in the hands of an experienced trader, but for most investors it is important to remember that success in trading is based not only on speed, but also on knowledge, intuition and the ability to anticipate long-term trends.