High Frequency Trading

By Jeff Fritz

As students graduate into the finance industry, what changes will greet them? What new trends will shape their professional lives? And more importantly, what do students need to know to prepare themselves for the realities of tomorrow?

These are the questions that the Arbitrage hopes to answer in this new and ongoing section, as well as hope that you, the reader, will derive a great deal of benefit from.

High Frequency Trading (HFT): a general term used to describe a different approach to stock trading that utilizes supercomputers, programmed with specialized algorithms, to execute transactions in milliseconds.

To those in the know, this is seen as a game changer that can result in huge profits for investment firms. In fact, high frequency traders, such as Goldman Sachs, together generated about $21 Billion in profits last year, the Tabb Group, a research firm, estimates.

However, there is a dark side to HFT. Ever since 1998, when the information age spurred the US Securities and Exchange Commission to open the trading floor to anyone who has Internet access, big trading companies have been looking for new ways to trying to maximize this innovation.

And by utilizing supercomputers to gather market data, scanning multiple marketplaces for upcoming trends and then trade at a speed not humanly possible, the issue becomes whether HFT presents an unfair advantage to those who own these special supercomputers and algorithms.

“It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane, of NYSE Euronext (New York Times).

One may rightly ask why this is unfair?

These big financial corporations have invested millions of their own money to purchase these supercomputers and develop the complex algorithms and programs they use to navigate the market.

Why should the government or society at large punish them for their innovation and ingenuity?

Aren’t they simply trying to maximize the returns to their investors?

To answer these questions, one must examine how specifically HFT affects the way trading is done in the stock market, the advantages that it offers its users.

Recently, electronic trading companies such as Direct Edge and Nasdaq CEO, Robert Greifeld, rushed to the defence of flash trading (a process where some orders to buy and sell shares—using HFT—are held for a split second before publishing them publicly), after US Senator Charles Schumer proposed that the Securities and Exchange Commission ban the practice.

A reason for this cover becomes clearer once you consider that NYSE Euronext, owner of NYSE, admitted that common investors may be getting worse prices because of flash trading (Bloomberg).

How’s this possible?

It’s because flash traders (again, using HFT) have the opportunity to gauge the supply and demand of certain stocks by holding orders for milliseconds. Specifically, by using these automated programs, traders can issue and cancel tiny orders within fractions of a second to see how much the slower traders were willing to pay.

For example, once these supercomputers see that some investors’ upper limit is $34.26, seconds later they can buy and sell the market price up to $34.25. In a way, it is almost like these flash traders are equipped a crystal ball they can use to predict the market’s movements seconds before it moves—and in this day and age, a few seconds is all the well-equipped need to rake in millions off the lowly common traders.

Even worse, this competitive advantage can become a chasm should those HFT companies rent server space within or close to the stock exchange’s servers in order to get market data and trading statistics faster—to an order of milliseconds—than other investors.