What Is High Frequency Trading?Summary: Stock markets around the world have seen new techniques take hold due to the increasing use and speed of computer trading algorithms. Most of these algorithms fall under the description of 'high frequency trading'. This page looks at the growth and impact of this technique. Some estimates suggest that the percentage of turnover by volume on major stock markets of high frequency trades has risen to over half by 2010. Yes, that means that potentially on some exchanges, 50% of all trades and value are traded automatically by computer. Pretty amazing. We had better take some notice! HFT (as it is often known) uses techniques called algorithmic trading to find minute differences in quotes. These algorithms use a dizzying array of mathematics to spot the differences and (often) to then 'arb' the difference. Arbitrage is the term used broadly to define taking financial advantage in different prices for the same asset. Usually, an arbitrage happens on different markets, or in different locations. Some very major corporations are listed on multiple exchanges for example and perhaps time or currency differences mean that the same stock is valued slightly differently offer the possibility to buy and sell at a profit. Since this is a tactic that has been used like crazy by many hedge funds, the opportunities seem to be limited. However, the HFT world uses lightning speed and accuracy to pull off it's trades. An example of this is called co-location which is a process of building the computer equipment used for trading in the same building as the actual stock exchange equipment. Why do this? Because the saving of milliseconds during a transaction can be profitable! In the old days, buyers and sellers needed to be near to an exchange to actually complete a trade. Then as computers took over, the trades happened electronically and there was no physical stock exchange location - everything was virtual. Now, as technology has advanced, and a stock exchange exists on a number of servers (perhaps 20 to 40) being closer to the stock market servers offers a business advantage.
In fact, most are simply limited companies. All they need to do is have the capital to trade with, the computer equipment to handle the trades and the algorithm that does the trading. With no outside investors, there has been little reason or legislation in place to monitor them. Regulators also suffer from the same problem that faces them when confronted by investment banks that are 'prop' trading and hedge funds - the best minds are lured into the funds by very high potential wages and bonuses. The regulators simply do not pay enough to be able to afford people that understand these techniques. There have also been a few 'odd' market happenings that have been broadly blamed on HFT that are raising the awareness of it to the public. The best example for many people as to why high frequency trading is a bad thing is the flash crash of 6th May 2010. In the space of roughly 20 minutes, the Dow Jones Industrial Average lost and then regained around 600 points. Intra-day, the loss was a touch under 1,000 points! However, some analysts think it was reasonably rational . Either way, many people are quite reasonably concerned that the investment and pension funds of the developed world are being played with in quite this way. It could easily be argued by many that HFT simply adds more systemic risk to a financial system that was proved in 2008 to have too much systemic risk. Whether good or bad, HFT looks set to continue to grow. A number of stock markets around the world (including India and Australia at the time of writing - in mid 2010) have plans to enable co-location next to their servers.
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