Posted in Finance Articles, Total Reads: 1416
, Published on 22 January 2013
High frequency trading has marked its presence in developed markets and has led to rapid development in the field of computing and networking. The concept and idea behind HFT is here to stay but requires regulation in order to avoid catastrophe like the one on May 26th 2010. And its entry into India has opened up career opportunities for many and this article intends to enlighten readers about what high frequency trading is and how it has changed the way trading is done these days.
Initially, traders used technical analysis and analyze news in order to make their trading decision. Then came a time when people started quantifying the way traders took decision and developed programmes which could take the same decision that a trader took,only faster. This marked the birth of algorithmic trading. Then traders started realizing that faster the decision making process of their algorithm, better off they will be. This lead to a race to reduce latency in every way possible and a new kind of traders emerged, the High frequency traders.
High frequency trading refers to transactions of large orders at a very high speed. HFT trades in securities like stocks or options, and uses complex algorithms to analyse multiple markets at a time and execute orders based on market condition. To achieve all this HFT requires effective algorithms and sophisticated technologies. High frequency trading is categorized with very low holding periods but the number of trades executed in a given day is very high. According to a financial research firm TABB Group (2009), HFT accounts for 61 percent of all US equity trading volume in 2009. Although we see some trending decline after 2009, the percentage in certain stocks are as high as 80. [Source: valotrading.com]
Certain opportunities exist in the market only for a few seconds; though the profit from these trades is very low, high volume can yield high returns. High frequency traders compete on the basis of speed with other high frequency traders and compete for very small, consistent profits. As a result, high-frequency trading has been shown to have a high Sharpe ratio.
2. PARAMETERS FOR SUCCESS IN HIGH FREQUENCY TRADING
Low latency can give you an edge over others but with lack of profitable trading strategies, speed will be of little use. In order to stay ahead of competition a team of highly skilled mathematicians and statisticians are required to detect high frequency trading opportunities. Development of a strategy is lengthy process which takes close to 6 months. The process starts with ideation; the idea is quantified and tested under various conditions. And the biggest problem is it’s easy to replicate a strategy followed by a competitor using reverse engineering, so the shelf life of a strategy is small. And certain strategies become obsolete with time, so there is a need to keep developing new strategies.
Types of Strategies:
There are six primary strategies in the world of High Frequency Trading. They are broadly segregated into three types:
Liquidity Providing: These strategies are basically to provide market liquidity. They are-
i. Rebate Trading: Providing liquidity in stocks by offering the bids and asks in order to collect the rebate provided by the exchange without requiring capital gains. Indian stock exchanges don’t provide rebate for providing liquidity so this type of strategy is not of use in India.
ii. Market Making: In these types of strategies, profits are earned by reducing the bid-ask spreads and enhancing the market liquidity. High frequency traders place orders on both side of the trade and earn from the bid-ask spread. So essentially in this case, a high frequency trader provides liquidity.
Trading the Tape:These strategies are used to gain from the movement of stocks’ price. They are-
i. Filter Trading: It uses those stocks that show significant changes in movement and/or volume.
ii. Momentum Trading: It gains by identifying temporary imbalances in the supply-demand and trade with short-term momentum before the equilibrium is restored.
Statistical Trading: These strategies are used to gain from mispriced securities. They are-
i. Statistical Arbitrage: It takes advantage of the price differentials between correlated securities and markets. ii. Technical Trading: It uses pre-defined recurring patterns in the stocks’ prices.[Source: T3Live.com]
2.2 LOW LATENCY
Latency is the time delay experienced in the system. Latency is experienced while receiving data from exchangeand while sending data to exchange. And latency is also experienced while processing the data to come up with an order decision. With high-frequency trades executing in microseconds, minimizing the delay between market data analysis and trade submission increases the effectiveness of trading algorithms. This maximizes the probability that a trade generated using that data can, and will, be executed.
For example, keeping other things such as trading strategies constant within high frequency traders, the one who will take maximum profit will be the one with lowest latency because his trade will reach the exchange faster and will get executed. High infrastructure spending is required to achieve low latency.
3. THE ROLE OF MESSAGING PROTOCOL
In high frequency trading, computers make the trading decisions and it communicates these trading decisions to the stock exchanges using a messaging protocol. There are various protocols, FIX and certain proprietary protocols. The Financial Information exchange ("FIX") Protocol is a series of messaging specifications for the electronic communication of trade-related messages. Certain stock exchanges have moved towards FIX protocol while others are still using proprietary protocol. The reason why many Indian stock exchanges have not moved towards FIX protocol is the cost involved with it. While the FIX specification is open and free, implementing FIX requires planning, software, and network services.
4. ADVANTAGES OF HIGH FREQUENCY TRADING
4.1 Reduced cost of trade
HFT has ensured that the bid ask spread are narrowed thereby reducing the cost of inherent cost involved in trading. High frequency traders provide the most competitive bid-ask prices in order to ensure that their trade gets executed and they earn huge profits by the sheer volume of their trades.
4.2 Increased Liquidity
A high number of trades provided by high frequency traders increase the liquidity in the market. Increased liquidity means that portfolio managers will be able to change their portfolio composition more easily rather than being prevented to trade due to high trading cost associated with low trading volumes.
4.3 Increased market efficiency
Due to high frequency traders, market information’s are reflected in the prices in the quickest time possible, thereby leading to faster price discovery. This adds to market efficiency where it’s difficult to consistently earn profit based on information available in the market.
4.4 Reducing market volatility
Since high frequency traders don’t allow prices to deviate from its fair value, this reduces that volatility in the market. A large buy or sell order can affect the market price of a security but high frequency trader acts on it to restore it to its fair value in the earliest thereby making sure that there are no huge deviations from fair value.
5. CASES AGAINST HIGH FREQUENCY TRADING
There have been a lot of cases accusing High frequency traders of taking undue advantage and causing mini crash. The most celebrated case against high frequency traders is that of May 6th 2010 flash crash.
On May 26th 2010, a trader at a large US mutual fund gave an order to sell unusually large number of E-mini S&P 500 contracts which exhausted the available buyers in the market and led to a steep decrease in its price. The high frequency traders who had bought a part of these contracts started selling following the sharp decrease in price. This resulted in high frequency traders trading among themselves and resulted in Dow Jones industrial average plunging about 1000 points (about 9%) only to recover to its initial level within minutes. Between 2:45:13 PM and 2:45:27 PM, firms traded 27,000 contracts which represented 49% of the total trading volume. At 2:45:28 PM, trading had to be paused for five seconds as the falling prices had triggered stop logic functionality. Once trading resumed, prices stabilized and the contract started to recover rapidly.
This event led to High frequency trading coming under the scrutiny of regulators all over the world.
[Findings regarding the market events of May 26th 2010 by Securities exchange commission]
High frequency trading is a natural evolution from conventional pit trading. The concept and idea behind it is here to stay but requires regulation in order to avoid catastrophe like the one on May 26th 2010. HFT has led to rapid development in super computers and networking. HFT has marked its presence in most developed countries and is slowly entering into emerging markets as well. With apt regulations in place, HFT is up for rapid adaptation in India as well with many firms entering into it in the last couple of years. And this opens up another opportunity for finance freaks in the country, with a fast paced and rewarding career.
This article has been authored by Aravind Ganesan and Rohit Maloo from IIM Indore.
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