Last Updated on June 3, 2021
The advancement of technology has revolutionized the execution systems of securities trading. Broker-dealers weren’t the only ones affected by these changes. It opened countless new doors for both institutions like hedge & mutual funds as well as retail traders. At the same time, a segment of old-school investors may be disappointed. That is because the best execution price they themselves could get was no longer the best possible price. The key to better prices is having a higher execution speed. Now, these High-Frequency Trading systems work at a pace impossible for people to keep up with. It’s no longer realistic to only rely on exchange listings to check prices.
This incredibly rapid trading system also held a great deal of opportunity for several ambitious start-up companies. Investors with considerable funds were more interested in playing it safe rather than trying to get creative. Meanwhile, the next generation was much better adept at the infrastructure of information technology. They realized that there’s more to trading than the size of your capital. Young programmers found themselves in a niche position in the market with the hand they were dealt.
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How Does High-Frequency Trading Work?
High-Frequency Trading (HFT) algorithms only hold most positions for a fraction of a second. They typically sell what they buy almost immediately. One of the benchmarks of the HFT strategy is that it doesn’t involve overnight positions. That characteristic makes its margin requirements close to null. Companies using this method bargain for favorable leverage with their brokers. They could, for example, hold $1,000,000 worth of positions while only having to put down a fourth of that. Every day they have 7.5 hours, which translates into 27,000 seconds, to trade with those funds.
For the sake of accuracy (and simplicity), let’s assume each day has approximately 10,000 seconds when it’s viable for the system to place trades. In each of these trades, the HFT trader aims to profit on the smallest possible price movement at around 0.00025% of the full price. This amounts to $2.50 per transaction using the available $1,000,000. By itself, that minuscule sum doesn’t even register for most investors. On the other hand, when repeated 10,000 times, it becomes $25,000 per day. Furthermore, it’s almost risk-free in a fully automated system. Under those terms, these High-Frequency Trading micro-enterprises are looking at a potential income of $6,250,000 over the course of a year of 250 business days. Comparing the required $250,000 collateral to the capacity for profit makes it seem like a promising investment opportunity.
HFT Companies Vs. Hedge Funds
Many ambitious investors have taken notice of this new technology. It didn’t fail to catch the attention of hedge & mutual fund managers either, although only after capital started flowing into these High-Frequency Trading companies. The other concern these fund managers have is that the high-speed trading between the HFT companies only inflates the volume without giving them enough information to evaluate the real value of the assets in question through technical analysis. The knowledge they built through years of studying & experience has a tough time competing with the profits of the High-Frequency Trading enterprises. This causes them to question the legitimacy of the profits made by High-Frequency Trading firms. Many even consider it borderline market manipulation. The reason being that these firms base their profits purely on their trades executing quicker than the ones resulting from the thoughtful analysis of professional traders.
The HFT Flash Crash & Aftermath
These grievances didn’t fall on deaf ears. HFT based companies experienced some restrictions as a result, causing their numbers to drop. During the initial HFT rush, automated systems accounted for over 70% of all trade volume. However, by early 2018 it fell to just 50%.
Today High-Frequency Trading mostly serves as a method to keep liquidity high, which also alleviated the worries of fund managers. Exchanges imposed new rules & capital requirements for these liquidity providers. Today their profit primarily comes from the exchange in the form of commissions. It’s their payment for helping to ensure market liquidity. In Europe, for example, these companies had to fit into the existing financial framework as outlined by part of the MiFID 2 regulations.
