What is High-Frequency Trading, Afterall?

What is High-Frequency Trading, Afterall?

High-frequency trading (HFT) uses quantitative investment computer programs to hold short-term positions in equities, options, futures, ETFs, currencies, and all other financial instruments that possess electronic trading capability. (Some securities, like Credit Default Swaps, for example, cannot be traded electronically, and are incompatible with investment algorithms.)

Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day.

“High-frequency trading” became a buzzword in 2009, when Goldman Sachs accused one of their ex-employees of stealing their “cash cow,” a sophisticated computer program capable of generating millions of dollars in trading profits over short periods of time. Yet, HFT has been around since the early 1980s, when several stock exchanges first decided to experiment with electronic trading. Since the 1980s, HFT has been growing in scope, speed and complexity.

At the heart of HFT is a simple idea that properly programmed computers are better traders than humans. Computers can easily read and process amounts of data so large it is inconceivable to humans. For example, frequently traded financial securities such as EUR/USD exchange rate can produce well over 100 distinct quotes each second. Each quote, or “tick,” carries unique information about concurrent market conditions. And while a dedicated team of human traders may be able to detect some tradeable irregularities in such fast-paced data over time, human brains are no match for computers that can accurately resolve and act upon all minute information infusions in the markets. Add to that the fact that computers seldom get ill, are easily replaceable, and have no emotions. Oh, and they’ve become really cheap.

The complexity of computer technology currently required by many HFT systems pales in comparison with that required to play modern video games. As video game purveyors drive the prices of advanced computer technology down, high-frequency trading becomes increasingly affordable to anyone with an inclination for quantitative analysis and programming. Call this a .com 4.0 revolution: the latest technology long deployed in many other industries has finally arrived on Wall Street.

Some high-frequency trading strategies are quantitative investing strategies deployed at high speeds. Other strategies, specific to high-frequency trading, work with market minutia, known as “microstructure.” In both cases, high-frequency traders feed off small intraday variations in prices and do not impact long-term investors.

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