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Benefits and Risks of High-Frequency Trading

HFT – The Basics

High-Frequency Trading (HFT) is essentially a subset of Algorithmic Trading (AT). Here, the algorithms act as middlemen between the sellers and the buyers, allowing high-frequency traders to capitalize on even the tiniest discrepancies in prices within the stock market, which may sometimes exist for a brief period.

Algorithmic trading is both computer-assisted, as well as rule-based. It makes use of dedicated software that is equipped to make trading decisions in an automated manner and place orders based on the same. Right from splitting large-sized orders to placing them at different times to managing the orders after submission – algorithmic trading does it all!

HFT is made possible by the algorithm’s capabilities to read and analyze high-speed real-time data feeds, identify appropriate price levels, place orders and detect trading signals complete with arbitrage opportunities based on news, events, and surprisingly speculation.

Golden Words

High-frequency trading will democratize investing, reduce costs, improve liquidity and reduce volatility, provided ill-informed technophobes don’t interfere!

– Irene Aldridge. Founder Able Alpha Trading; Author, High-Frequency Trading Opportunities

Benefits of High-Frequency Trading

Fortunately for all, High-Frequency Trading (HFT) is as advantageous as it is exciting. Let us take a quick look at some of its inherent benefits –

• Enhanced Profitability

Right from allowing trading large volumes of securities at once to allowing high-frequency traders to profit from tiny fluctuations – HFT ensures significant returns for the investors.

• Added Training Opportunities

The ability of trading algorithms to scan and analyze multiple markets and exchanges facilitates high-frequency traders to identify additional trading opportunities, complete with the opportunity to arbitrage even the slightest price differences for the same asset.

• Improved Market Liquidity

While debatable to some extent, high-frequency trading increases competition in the stock market owing to the faster and larger trade volumes. Not only does this help intensify the market liquidity, but it also makes the market increasingly price efficient.

Moreover, the more liquid a stock market, the less is the risk associated with it. This ensures that the price that the seller quotes and that the buyer wishes to pay moves closer together, thus reducing unwanted volatility.

Risks of High-Frequency Trading

Of course, not all that glitters is gold. As beneficial as HFT is, it also comes with a wide array of risks associated which are often the cause of controversy amongst trade groups, finance professionals, market makers, and even regulators.

Before you jump into the world of High-Frequency Trading, we believe it’ll be in your best interest to know all about the risks associated with it!

• Increased Chances of Major Losses

As the name suggests, high-frequency traders are bound to hold their portfolios for a brief timeframe and liquidate their position mainly within a day. While this makes the risk-reward ratio exceptionally high, this also brings to light the increased chances of incurring significant trading losses since the entire transaction is often dependent on a fraction of cents.

• Creation of ‘Ghost Liquidity’

While liquidity is one of the benefits of high-frequency trading, some argue that it is only a ‘ghost liquidity that high-frequency trading creates. Since the securities are often held for terse bursts of time, sometimes even seconds, the resultant liquidity is good as none.

Why? Well, it is because before a regular investor can even place an order, high-frequency traders have already traded the same stock multiple times, which results in the quick fading away of the seemingly high liquidity created by such trading.

• No Place for Smaller Players

Since there is a high cost of entry, it is almost impossible for standalone investors, small-scale financial institutions, and investment banks to indulge in high-frequency trading. While this may essentially not seem to be a risk, it certainly doesn’t live up to the definition of a fair marketplace.

• Ethical Disbalance

High-frequency trading inherently needs the traders to buy and sell smaller volumes quickly without holding on to the securities for any longer than a day or two. This ultimately works against the interests of the investors who wish to follow the long-term strategy and buy or sell in bulk.

• Market Manipulation Strategies

Many high-frequency traders are known to indulge in illegal stock market manipulation techniques like spoofing and layering, which can result in enhanced market volatility and even cause adverse market impact. The Flash Crash in 2010 is said to have been caused as a result of such malpractices.

Moreover, large organizations can even afford to invest in algorithms that can initiate multiple orders at once, only to cancel them a few seconds later, thereby creating a fleeting rise in prices. Such market manipulation is immoral and saves the organizations from trading losses, thus giving them an unfair advantage. Still, it can hurt the overall sentiment of the financial markets in the long run.

HFT Infrastructure Needs

Now that you are well aware of the benefits and risks of high-frequency trading, we believe you are all set to take the plunge and join this exciting investment avenue. If so, here is a consolidated list of infrastructure that you ought to have in place to kick-start –

  • High-speed computers, complete with high-performance hardware. Please keep in mind that your computers can and will need regular updates and upgrades, which may often prove to be costly.
  • Co-location is a high-cost facility that is near the exchange servers. This will help reduce any time delays and will help you stay ahead of the curve.
  • Real-time data feeds at all times to ensure timely order placement and other actions needed for profit maximization.
  • Latest computer algorithms.

We hope that you now know all about High-Frequency Trading and the benefits, risks, and infrastructure needs that can help you enhance your investment strategy and allow you to earn maximum profits day in and day out in the financial markets of your choice!

High-Frequency Trading FAQs

What are some of the challenges in HFT?

High-frequency trading has been quite challenging from the very onset. Some of these challenges include –

  1. High cost of entry that only large institutional investors can bear
  2. Trading Algorithms’ development
  3. Need for high-speed trade execution platforms
  4. Frequent necessities of high-cost upgrades
  5. High subscription charges towards data feed
  6. Crowded marketplace

Is high-frequency trading profitable?

Yes, definitely so. As per the Dow Jones industrial average, passive HFTs are known to earn annualized returns of 23.22%; aggressive HFTs can easily achieve returns of 90.67%.

Can anyone do high-frequency trading?

Ideally yes. However, to do high-frequency trading, it is essential that individual investors meet the criteria for being a ‘professional trader’ by the IRS and that you have ample funds to begin with. If the high cost of entry is something you can afford, you can become a high-frequency trader.

Meta Title – High-Frequency Trading Has Many Advantages, But Is High-Frequency Trading Bad?

Meta Description – High-Frequency Trading is an algorithmic trading subset that enables investors and organizations to make profits from even the slightest price fluctuations in the market.

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