High Frequency Trading: What’s True, What’s False and What’s Next
*This article is for general information purposes only and does not constitute Eze Castle Integration trading or technology advice as to any particular set of facts.
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It has dominated the headlines and been targeted by lawmakers looking to repair and regulate a financial system that has taken the brunt of blame for our current economic landscape. What exactly is high frequency trading? Why has it become a controversial practice? How will our financial system change if new restrictions are put into place? In this article, we’ll examine what high frequency trading is, how it works and why it’s in all the headlines.
High frequency trading can be defined as the use of quantitative-driven strategies to execute strategies with a holding time of less than one day. In other words, firms are trading in a rapid manner, while cutting holding fees and subsequently increasing profit margins. High frequency trading is algorithm-based and originated in the equities markets, but is currently extending its reach to other markets, including futures and commodities.
High frequency trading occurs when traders are able to quickly identify and execute pre-developed strategies across markets and move from position to position in just milliseconds. Traders are able to develop complex algorithms that look at numerous variables to determine exactly when to buy or sell specific stocks. Furthermore, some high frequency trading shops are able to employ a strategy that relies on the ability to see certain orders a few milliseconds before the rest of the market – these are known as flash orders. Firms then use these flash orders to create micro-markets around a specific stock across exchanges.
Current trends show that as high as 80 percent of orders are canceled at the last minute, which indicates firms are using high frequency trading to determine at what price other buyers will be willing to bid on an order. For example, if an organization has 200,000 shares to sell, and they want to determine the optimal selling point, they might first offer 5,000 shares at a certain price. If they see that there are no immediate bidders, they can drop the bid instantly, and continue to do so in a matter of milliseconds until they determine the highest price buyers will be willing to bid on. Likewise, traders also have the ability to
increase their bids instantly if they determine buyers will be willing to bid high enough. It has become a controversial practice in the financial services industry – and accounts for approximately 50 percent of all U.S. equity trading – but some speculate that high frequency trading is still largely misunderstood.
The Major Players There is a common perception that high frequency trading is reserved for the biggest and best firms – those who have virtually unlimited capital and resources. This assumption, however, is largely untrue. In fact, approximately ten percent of firms that use high frequency trading are small entities with less than five people, according to BNY ConvergEx Group.
Another common assumption is that firms require a great amount of capital to execute high frequency trading strategies, when in fact, that is not necessarily the case either. Yes, there are initial capital...