High-frequency trading: what is HFT and how does it work?

What is high-frequency trading?

High-frequency trading, or HFT, is a strategy that involves executing a large number of orders quickly – within seconds. The aim is to capture a small amount of profit, sometimes a fraction of a cent, on each trade.

HFT is also known for its high turnover rates, as trades are only held for extremely short timeframes.

It's a type of algorithmic trading, as it requires high-tech computers to analyse market conditions and execute trades as fast as possible. Complex algorithms will be looking at thousands of markets to identify emerging trends in nanoseconds and trigger hundreds of orders.

This has meant that typically HFT is used by institutions that have access to the required equipment – such as investment banks and hedge funds.

The method of trading first became popular when exchanges started offering incentives for companies to add liquidity to the market. These were introduced after the 2008 financial crash, to help reassure investors. An example is the New York Stock Exchange's Supplemental Liquidity Providers group which receives rebates for adding competition to the market.

Advantages of high-frequency trading

The main advantage of high-frequency trading is that it enables traders to find profits from extremely small price movements.

Plus, the use of algorithms means traders can spend less time monitoring markets themselves and make decisions based on rationality rather than emotions.

Some argue that HFT adds more liquidity to markets, which can lead to tighter bid-ask spreads and lower costs for traders. The higher liquidity also means the market has less risk associated with it, as it's more likely that someone will take the other side of a trade.

Disadvantages of high-frequency trading

High-frequency trading is still a highly controversial practice. Critics argue that it creates an unfair market, as it allows larger companies with access to more powerful technology to gain an advantage over retail traders. And it might even enable them to 'jump the queue' to better prices because of the faster connection to price data.

Even the liquidity HFT creates only lasts a few seconds, so it's often dubbed 'ghost liquidity' as it has no real benefit to most market participants, yet large firms receive fees from exchanges for the service.

Another potential disadvantage for any traders who do manage to perform HFT is that the positions are so large and held for such a short amount of time that the strategy has an exceptionally high risk-reward ratio. A lot of traders will choose to mitigate these risks with stop-loss orders, to ensure positions are closed at a specified level of loss.

Finally, HFT has been the subject of much debate from regulators across Europe and the US as it has also been linked to volatility and market crashes – such as the Flash Crash in May 2010, which the US government blamed on a massive HFT order that triggered a sell-off.

Although there have been calls to ban HFT practices, it hasn’t happened yet. The method itself isn't inherently manipulative or fraudulent - according to the CFA Institute - but it does increase the likelihood that firms will engage in manipulative and fraudulent activities.

High-frequency trading strategies

High-frequency trading strategies tend to have similarities to algorithmic strategies, given both lean on technology for fast execution.

Let's take a look at some popular HFT strategies.

High-frequency arbitrage

High-frequency arbitrage trading involves buying and selling large quantities of an asset that has a price imbalance to exploit slight price differences for the same asset on different exchanges.

A study by the University of Chicago looked at data from 2011 to show that these opportunities only last for half the time it takes to blink. They studied the price difference between futures and exchange-traded funds that track the S&P 500 (US SP 500). In theory, these markets should be perfectly correlated, but there is an inefficiency of 250-millisecond intervals.

As that’s not enough time for a human to register the prices, let alone execute a trade, arbitrage high-frequency strategies have to be automated with algorithms.

Index arbitrage

Index arbitrage strategies are based on exploiting periods where pension funds and investment firms rebalance their offerings on global indices to ensure they reflect the underlying index accurately. This usually happens quarterly.

For arbitrage traders, this creates a small window of opportunity to buy and sell shares that will be added to, or removed from, index funds.