What is High-Frequency Trading?

For a short term trade to be immensely profitable, the stock must rise in price by a huge margin. But, it is not very common for a stock price to rise by a huge margin in just a few weeks or months. It requires high capital investments to make a profitable trade.

For example, if you invest Rs 10,000 in a stock priced at Rs 50 for three months, you would need the stock to go up to Rs 70-80 for good returns. However, for Rs 50 stock to reach such a level can take years. It can go to 55 or 57 in three months if the market is in an uptrend and the stock fundamentals are apt.

Since the prices do not fluctuate often, how can investors take advantage of these minimal price fluctuations and make profits out of them using an online trading app? In such situations, they prioritize the number of orders rather than the price fluctuations. Big fund houses and professional traders who make profits by the price fluctuations in a matter of seconds use algo trading and execute high-frequency trading. This blog will detail everything you need to know about high-frequency trading strategies and how you can use them to make profits.

High-Frequency Trading

An integral part of algo trading, high-frequency trading is a trading strategies that involves buying and selling shares by using powerful computer programs. The main aim behind high-frequency trading is to execute a large number of orders in a fraction of a second. The process of high-frequency trading uses complex artificial algorithms to evaluate and analyse various securities markets and execute a large volume of orders at an immensely fast pace.

High-frequency trading believes that if the orders are high in number and are executed faster than others, the net profits realised through multiple trades are higher. High turnover rates and order-to-trade ratios are generally seen with high-frequency trading. As it demands specially made computers with high-level software, the process is generally undertaken by large investment banks, corporate houses and hedge funds.

How does High-Frequency trading work?

The idea behind high-frequency trading is fairly simple. The larger the volume of trades, the higher the profits. The notion is a profitable alternative to holding the stocks for the near short term and waiting for the prices to go higher. If you have ever monitored a stock, you would have seen how fast the price fluctuates.

Even if the price fluctuates by Rs 1 or 2, it becomes a profitable venture for someone undertaking high-frequency trading. All the decisions regarding portfolio allocation are made by artificial quantitative models. The models are pre-fed specific information by the owner, and the success is based on the ability of the model to process huge amounts of information and data, which is impossible for a human investor to undertake. Among high-frequency traders, the competition is between who can execute the highest number of trades in the least amount of time. Whoever achieves that objective, makes the highest profits.

What is Algorithmic Trading?

Algorithmic Trading is the process of using pre-programmed trading instructions to execute trading orders at high speed in the financial market. Investors and traders use trading software and feed it trading instructions based on time, volume and price. Once the set instructions are triggered in the market, the trading software executes the orders set by the investor.

Generally, algorithmic trading is used by Mutual Funds, Hedge Funds, Insurance Companies, Banks etc., to execute a large number of high volume trades that are otherwise impossible for humans to undertake. For investors personally, algorithmic trading allows more trades in a limited amount of time without the impact of human emotions and trading errors.

Strategies of High-Frequency trading

Here are some high-frequency trading strategies:

• Market Making: This is a firm or an investor who is ready to buy and sell shares at a publicly quoted price regularly. Many high-frequency trading firms used market making as an effective strategy by using a predetermined set of high-frequency trading strategies to place a limit order to sell or buy limit order. High-frequency trading firms do this to earn the bid-ask spread and make profits.
• Quote Stuffing: This strategy in high-frequency trading involves buying and selling a large number of orders as quickly as possible to create confusion in the market and among investors. Because of this confusion, the trading volume rises, allowing high-frequency traders to get profitable trading opportunities that they use to initiate multiple trades again.
• Tick Trading: Under tick trading, powerful computers observe the flow of quotes and the market information embedded in the market data and trading volumes. The aim behind tick trading is to recognise the beginnings of huge orders being placed by other HFT traders in the market.
• Statistical Arbitrage: This type of arbitrage is used to identify the price differences among various securities across different exchanges or markets. High-frequency trading uses statistical arbitrage in liquid securities such as bonds, equities, currencies, futures etc. Such high-frequency trading strategies may also include traditional arbitrage strategies such as interest rate parity etc.

Benefits of High-Frequency Trading

Here are the benefits of high-frequency trading:

• Quick profits: High-frequency trading allows investors to make quick profits which they increase by executing a large number of trades. Even if there are small price fluctuations, investors can make hefty profits using high-frequency trading strategies through the bid-ask spreads.
• Increased opportunities: High-frequency trading includes powerful computers and software capable of scanning and analysing multiple markets at once. This allows investors to identify arbitrage opportunities and make profits by buying from one exchange and quickly selling in the other.
• Enhances Liquidity: It is seen that high-frequency trading enhances liquidity in the market. As the HFT results in increasing competition and the volume of trades, it declines the bid-ask spread, leaving the prices to be more efficient than before. Furthermore, as the liquidity increases, the market functions more transparently and flexibly and ends up being less risky for other investors.
• Less human error: High-frequency trading is always more effective than traditional trading as it avoids the interference of humans. Humans can make mistakes while trading or can enter or exit at the wrong time. Furthermore, humans can’t execute such a high volume of orders at the pace at which it is done during high-frequency trading.

Disadvantages of high-frequency trading

• Lack of regulation: As high-frequency trading includes such complex algorithms and software, it is difficult to monitor and regulate. Furthermore, there is very less consensus about high-frequency trading among scholars and finance professionals, making it a controversial subject.
• Replacement: High-frequency trading generally meets with criticism as it has replaced numerous brokers and dealers with software and algorithms. It is also believed that it is not a good process to undertake as investing requires human intellect at most times to make profits. Going by data and information is not enough for a comprehensive trading strategy.
• One-sided profits: Retail investors never have the required infrastructure to undertake high-frequency trading. As a result, only large companies with the required infrastructure make profits using the strategy, and at the cost of retail investors. Hence, the liquidity that arises is commonly called ‘Ghost liquidity’.

Final Word

High-frequency trading prioritises the trading volume over time and executes trades that don’t even last for a fraction of a second. However, as high-frequency trading is one of the most complex trading techniques, it requires a high level of computing and algorithmic knowledge. If you want to understand more about algorithmic trading and its factors, you can visit the IIFL website and read related blogs.

Frequently Asked Questions

Is High-Frequency trading profitable?

Yes, high-frequency trading is undertaken using complex algorithms and powerful computers, and it is highly profitable for traders.

What are High-Frequency trading strategies?

Some of the high-frequency trading strategies are market making, statistical arbitrage, event arbitrage, quote stuffing, tick trading, index arbitrage etc.

What are interesting facts about HFTs?

High-Frequency trading can execute multiple thousands of orders by buying a huge number of stocks and selling them in the blink of an eye. The only thing the investor does is to press a button and watch the profits flow.