High-frequency trading (HFT) is a means to manage rapid order flow to markets. High-speed computers at an HFT firm can submit thousands of orders at a time to exchanges using special algorithms. These orders are usually cancelled and replaced; it is estimated that only 10% of HFT orders execute. This phenomenon occurs because HFT systems continually fish for smaller bid/ask spreads that may immediately trigger trades. If no trades are triggered, the order is cancelled. However, if such trades are triggered, the HFT firm jumps in by trading to capture the spread – it buys at the lower ask and simultaneously sells at the higher bid. This only works if both legs are transacted at the same time. Any delay in one leg will allow market prices to adjust to the new spread, and the HFT firm can lose money. While the potential profit per share is very small (estimated between 1 and 2 tenths of a penny per share), when multiplied by high volumes and frequent executions, HFT can be a sizeable money-maker.
It is estimated that tens of billions in profits are realized annually through HFT. Participants include prime brokers, hedge funds, and independent investment firms. This high-stakes arena has seen brokers such as Goldman Sachs sue former employees for stealing HFT trading algorithms. Competition is so cutthroat that HFT firms actually try to physically place their computers as close as possible to exchanges and alternative trading systems (ATS) to reduce communications latency. Some go even further and pay to have their equipment in the same room as that used by exchange/ATS order-matching computers. The reason for such heroic order transmission strategies is that a delay as little as 1/1000 of a second can mean the difference between arriving first (and thus executing the trade) or sitting in a queue with an open order.
Besides capturing a tiny profit per share on each successful trade, HFT firms can also generate cash flow via perfectly legal rebates from exchanges in return for the enhanced trading volume. With these incentives, it is not surprising that almost ¾ of U.S. stock trading volume is attributed to HFT programs.
Anything this lucrative can be expected to engender its share of critics. Some worry of increased volatility in response to breaking news. Others feel that dealers, market makers and specialists cannot compete with customers since the latter group gets first shot at existing bids and asks. That’s because customer have a higher trade priority than do dealers – which actually makes sense since dealers are there to make markets, not monopolize them. The problem is that the liquidity provided by HFT engines can be quickly withdrawn when news occurs or volatility reaches extremes, thus making the market-makers job much more risky in difficult markets.
HFT, sometimes referred to as black-box trading, would seem to remove the human element from trading. A mistake on the tape can lead to a flurry of HFT activity that can easily disrupt trading operations. If such activity causes rapid discontinuous downside movements, other customers may have any stop-loss orders bypassed and sustain a larger loss than anticipated. The future of HFT is not clear – it will be interesting to see if the additional liquidity provided by HFT will compensate the trading community for possible downside risks.