An outlook at High-Frequency Trading

3 mins read
by Angel One

Technology has made deep roots in every area of our lives. Stock market is no different. On one hand, technology has made trading easy and simple for beginners with simplified trading platforms now available on the screens. On the other hand, it has created new avenues of trading for the big and old players, through High-Frequency Trading (HFT).

What is High-Frequency Trading?

HFT is a method of trading that uses powerful computer programs to analyze trading data and execute a large number of orders in a fraction of a second. To do so, it uses complex algorithms, making it a subset of algorithmic trading (algo trading).

Algorithmic Trading is the automated trading process that makes use of pre-programmed trading instructions to transact trade in the market. The pre-programmed instructions are fed into trading software, based on the volume, time, price, etc. The trading software executes the trade once the instructions set by the investor are triggered in the market.

What makes HFT attractive in the stock market?

The following features of HFT have made it a demanding trading tool in the financial markets:

  • Conventional trading is dominated by human emotions that influence discipline and risk management, the essential attributes of trading. With automation, HFT eliminates the emotional bias associated with conventional trading.

  • Timing is the essence of trading. Co-location allows HFT to know the security prices in split seconds before the other investors due to discrepancies in connecting speed. The low latency gives a huge edge to HFT:

  • Early access to trading data than other investors

  • Allowing execution of trades in fractions of seconds

  • With the possibility of executing a large number of trades in fractions of seconds, huge profits can be made even with the minimal price fluctuations

  • HFT may infuse the liquidity in the market by reducing the bid-ask spread

Criticism of HFT

HFT has drawn flak from various stakeholders of the Stock market. Some of them are:

  • HFT provides an edge to the big players to make profits at the expense of small retail investors.

  • HFT is said to create ‘ghost liquidity’ i.e, the liquidity created by HFT stays in the market only for milliseconds/seconds and is taken away by the time the retail investors can benefit out of it.

  • Colocation has raised the debate of inequality as it is said to have given an unfair advantage to HFT.

  • HFT is linked to high market volatility. With the speed at which a high-frequency trade takes place, an endless loop or a faulty algorithm can lead to a flash crash in the market like one in the US market in 2010.

HFT and algorithmic trading are a part and parcel of most global markets. HFT is mostly used by institutional investors like FPIs, mutual funds, ETFs, and Hedge Funds to execute trades. Stock market is still divided about whether HFT is beneficial or not, with even the Stock market regulator SEBI, is still to come up with regulations on HFT. Though HFT remains debatable, it has made its way into the stock market.