Using powerful computer algorithms to execute many orders in fractions of a second is big business but not necessarily easy for the general public to understand. High-frequency trading (HFT) firms regard their methods and strategies as trade secrets, further enshrouding them in mystery. As discussed below, HFT involves secrecy, strategy, and speed.
Key Takeaways
- High-frequency trading firms can be divided broadly into arbitrageurs, proprietary trading, and market makers.
- Their strategies include different forms of arbitrage, long/short equity, and market making.
- HFT firms rely on the ultrafast speed of computer software, data access, and connectivity with minimal latency(delay).
- Firms engaged in HFT face risks related to software anomalies, dynamic market conditions, and regulations and compliance.
- HFT firms are frequently accused of having an unfair advantage and causing increasing volatility. However, proponents say that they add liquidity to the market.
What Are High-Frequency Trading (HFT) Firms?
Estimates put about half of all trading across the U.S. (up to 60%) and Europe (about 35%) in the high-frequency category. HFT companies employ diverse strategies to trade and force returns from faster-than-lighting trades. The strategies include arbitrage; global macro, long, and short equity trading; and passive market making.
HFT firms rely on the ultrafast speed of computer software, data access (Nasdaq's TotalView-ITCH, the New York Stock Exchange's OpenBook, etc.), and network connections with minimal latencyor delays. The faster the trades, the quicker data can be moved from trading system to trading system, and the better the (micro) edge a firm has. Trades are measured in millionths of a second or microseconds; the time it takes for trades to move from Chicago exchanges to New York exchanges, for example, is measured in small fractions of microseconds.
Let’s explore more about the types of HFT firms, their strategies, who the major players are, and more.
How High-Frequency Trading (HFT) Firms Work
HFT firms generally use private money, technology, and strategies to generate profits. High-frequency trading firms can be divided broadly into three types.
- Independents. The most common and biggest form of HFT firm is the proprietary firm. Proprietary trading(or "prop trading") is executed with the firm’s own money rather than the money of its clients. Likewise, the profits are for the firm and not for external clients.
- Subsidiary of a broker-dealer firm. Some HTF firms are subsidiaries of broker-dealer firms. Many have proprietary trading desks, where HFT is performed. This section is separated from the firm's work for its regular, external clients.
- Hedge funds. Lastly, HFT firms also operate as hedge funds. They focus on gains from inefficiencies in pricing across securities and other asset categories using arbitrage.
Before the Volcker Rule was instituted after the 2008 financial crisis to ban banks from using their own capital for certain investment activities, many investment banks had segments dedicated to HFT.
How Do High-Frequency Trading (HFT) Firms Make Money?
Propriety traders employ many strategies to make money for their firms; some are commonplace, and others are more controversial. Note that these are all extremely short-term strategies, using automated moves using statistical properties that would not give success in buy-and-hold trading.
Directional Trading
Directional strategies, or very short-term buying and selling, involve taking short-term long or short positions on the anticipated upward or downward moves of prices. These strategies require considerable liquidity to work. Some directional approaches focus on predicting price shifts more quickly than other market players, which means having advanced analytical tools and ultrafast processing networks. For example, order anticipation strategies might try to foresee or infer that a large buyer or seller is in the market.
Providing Liquidity
Other sources of income for HFT firms are the fees they receive for providing liquidity for electronic communications networks and some exchanges. HFT firms act as market makers by creating bid-ask spreads and churning mostly low-priced, high-volume stocks many times daily. By constantly buying and selling securities, they ensure that there is always a market for them, which helps reduce bid-ask spreads and increases market efficiency.
Arbitrage
Another way these firms make money is by looking for price discrepancies between securities on different exchanges or asset classes. A proprietary trading system looks for temporary inconsistencies in prices across different exchanges. With the help of ultrafast transactions, they capitalize on these minor fluctuations since the speed of HFT allows these firms to execute arbitrage trades quickly before the market can adjust and the opportunity disappears. This is called statistical arbitrage.
Structural Strategies
The strategies above may involve structural techniques designed to capitalize on weaknesses in the market or other parties in the market. Traders equipped with the fastest market data and processing networks can profit by engaging in trades with participants who have slower data reception and processing. Their delay means these participants haven't yet adjusted their prices to mirror the latest market developments, and those with faster HFT processes can move in to take advantage.
Rapid Price Movements
HFT firms also make money by engaging in momentum ignition.The firm might aimto cause a spike in the price of a stock by using a series of trades with the motive of attracting other algorithm traders to alsotrade that stock. The initiator of the whole process predicts that after the artificially created price movement, it will revert to normal, and a position early on can lead to profit. When this practice involves market manipulation, the Securities and Exchange Commission (SEC) has deemed it illegal.
| High-Frequency Trading Firm Strategies | |||
|---|---|---|---|
| Market Making | Arbitrage | Long/Short Equity or Directional | |
| Liquidity provision: Provide liquidity, ensuring enough buy and sell orders. | Market-neutral arbitrage: Aims to be unaffected by market movements. | Short-term momentum: Taking long (buying) or short (selling) positions based on the asset's short-term price momentum. | |
| Rebate-driven strategies: High-volume trades to earn transaction rebates. | Cross-asset, market, exchange-traded fund arbitrage: Exploits price discrepancies between related assets or markets. | Sniffing, Pinging, and Sniping: These tactics can be part of a broader long/short equity strategy where traders aim to gain information on market trends or the intentions of other traders. | |
| Quote matching: Employed to ensure àtrader's orders are competitive and have a higher chance of being executed quickly. | Latency arbitrage: Leverages speed advantages to exploit pricing inefficiencies. | Spread capturing: Earn profits from the spread between buy and sell prices. | |
The Players
The HFT world involves firms ranging from boutique companies to the biggest players on Wall Street. Here's a list of some of the largest HFT firms by volume traded, according to the SEC:
- Citadel Securities: Based in Miami, it has personnel devoted to commodities, credit and convertibles, equities, global fixed income and macro, and global quantitative strategies.
- Virtu Americas: Based in New York City, Virtu was founded by Vincent Viola, former chair of the New York Mercantile Exchange. The firm offers settlement, clearance, direct-market-access trading, electronic access, and other trading services.
- G1 Execution Services: A subsidiary of G1 Trading, the firm engages in electronic market-making and other liquidity and high-frequency trading activities.
- Two Sigma Securities: A broker-dealer based in New York and founded in 2001. The company focuses on quantitative analysis of historical price patterns and other data for trading.
- Wolverine Securities: Part of Wolverine Trading, a financial firm focused on market making and proprietary trading.
- Jane Street Capital: A global proprietary trading firm that uses quantitative analysis while focusing on price discovery and liquidity provision.
- UBS Securities: The brokerage arm of UBS Group, it offers investment banking and securities trading services, including market-making activities.
- Goldman Sachs & Co.: Goldman engages in a broad range of trading activities, including market making and proprietary trading.
Risks
The firms engaged in HFT face risks that include software anomalies, quickly changing market conditions, and compliance. Reliant on technology, HFT firms are quite vulnerable to programming glitches, system failures, and cybersecurity threats. An early, infamous case involving Knight Capital, a then-major HFT firm, shows just how fast things can go wrong in these firms despite their sophistication. After a software glitch, Knight accidentally bought and sold millions of shares Aug. 1, 2012, in 150 stocks in that day's first 45 minutes of trading, resulting in a loss of $440 million. This almost bankrupted the company.
HFT firms also face significant risks during periods of high market volatility. Rapid price moves can lead to large, unexpected losses, especially if the firm's algorithms don't perform as expected under stress. Changes in market structure, trading volume, or liquidity can affect the firms' HFT strategies, leading to reduced gains or greater losses.
Pros and Cons of High-Frequency Trading
Pros
- Detecting more opportunities. The technology HFT firms use is able to process and analyze large amounts of data quickly and effectively. This saves costs and means identifying potentially great opportunities more frequently.
- Speed. Computer programs can analyze large amounts of data in little time. For traders with access to this technology, that means being able to capitalize on opportunities that may exist for a very brief period.
- Liquidity. HFT brings more buyers and sellers to the market, which increases liquidity and reduces big bid-ask spreads.
Cons
- Potentially unfair advantage. Not everyone can access the advanced computer algorithms at the HFT firm’s disposal. This gives these firms an unfair advantage over other investors. HFT can respond to market developments quicker and profit from discrepancies others haven’t noticed.
- Increased volatility. Algorithms can trigger heavy automatic buying or selling activity, leading to sudden swings in the prices of assets. The flash crash of 2010 is an example. The Dow Jones Industrial Average rapidly declined, losing almost 1,000 points within minutes before quickly recovering. Given how automated trading systems reacted initially, HFT was widely cited as contributing to volatility.
- Trading errors. Sometimes, automated decisions can go wrong, leading to heavy losses.
Skills Needed To Get a Job at an HFT Firm
Getting hired in HFT means having strong technical skills, an advanced knowledge of financial markets, and the ability to make decisions quickly based on the available data. Here are some additional key skills you'll want stressed on your resume:
Advanced quantitative abilities: Most HFT firms look for candidates with a deep background in mathematics, statistics, physics, computer science, or engineering.
Programming experience: Skills in programming languages, including the latest in AI and LLM, aren't a must, but they soon will be. HFT relies heavily on algorithms and automated systems, so the ability to develop and work with them is valuable.
Analytical skills: The ability to analyze large data sets quickly to derive conclusions in complex areas and solve intricate problems under pressure.
Fast but precise: In HFT, milliseconds matter. The ability to work quickly and accurately is thus essential.
Risk management: Understanding and managing risk is a crucial skill. You'll need to consider the potential downside, not just profits, in the large volume of rapidly executed trades your firm manages.
Gaining these skills requires a mix of advanced schooling (an M.A. and Ph.D. in a quantitative discipline) and experience through internships and industry experience. But even in a field known for algorithm-based decision-making, soft skills are necessary for longevity. Communicating your ideas, aiding in teams, and adapting to changes will serve you well in this or any part of the financial sector.
Is High-Frequency Trading Still Profitable?
Yes, though its profitability varies in different market conditions, how well competitors are keeping up with technological advances, and regulatory changes. In its early years, when there were fewer participants, HFT was highly profitable for many firms. As more companies entered the HFT space, profit margins thinned. The buy-in for companies now is significant. While smaller firms do exist and leverage advanced quantitative strategies, it's also a field that requires high levels of computing power and the fastest network connections to make HFT viable.
How Does High-Frequency Trading Increase Liquidity in the Financial Markets?
Despite concerns raised by some market participants about the unfairness of HFT, the SEC has defended the practice because it increases liquidity. That's because HFT firms are continuously placing buy and sell orders, which can make it easier for other traders to execute their trades quickly and at more stable prices. This should lead to narrower bid-ask spreads and more efficient markets. However, some critics argue that HFT firms may quickly withdraw their trades when there's market stress, setting off more volatility and making it harder for other traders to buy or sell their positions.
Is High-Frequency Trading Illegal?
HFT trading is legal, provided the firm is employing legitimate trading methods. HFT firms operate under the same regulations as every other market participant. The SEC has noted that it sees HFT as ultimately good for market liquidity.
However, certain practices within HFT, such as market manipulation or trading on nonpublic information, are illegal. The SEC and other financial regulatory bodies worldwide closely monitor trading activities, including HFT, to ensure compliance with securities laws and to maintain fair markets not given to extreme volatility.
The Bottom Line
HFT firms have been around for a couple of decades, form an important part of investment markets, and account for about 50% of equities trading volume across the U.S. and Europe. Critics have long argued that these firms have an unfair advantage and are to blame for increasing volatility in the markets since their rise. However, they also help to add liquidity to the market and reduce bid-ask spreads.
Article Sources
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