Introduction to High Frequency Trading:
Take a second to envision a stock market and hold that thought.

If what came to mind were trading pits, adrenaline fueled men shouting over one another and ticker symbols, you might be stuck in the past. As so much in life, technology has drastically revolutionized the financial industry. Trades that once took days, hours, and minutes now have been reduced to mere seconds, milliseconds, and microseconds.

If you want to put that sort of speed into perspective, try this:

Blink as fast as you can; divide that number by 10; that’s a millisecond.

Welcome to High Frequency Trading.

What Is HFT and Why has it become Relevant:
High Frequency Trading (HFT) is a form of buying and selling securities as part of an automated and self-regulating computer algorithm which substitutes a human broker. A basic algorithm is nothing more than a computerized set of “if … then …” conditional statements. A HFT algorithm on the other hand, allows a computer to independently and flexibly pursue a multitude of trading strategies at unprecedented speeds.

What edge does a mathematical algorithm have to offer over the average broker? For starters, computers are not plagued by our constraints of fatigue or persistent needs, meaning they can be fully operational 24 hours a day. Algorithms are designed to be the smarter and faster broker. In fact, over a thousand times faster.

In 1998 the Securities and Exchange Commission (SEC) – the institution responsible for the regulation of the U.S stock market – introduced a basic sense of computerized high frequency trading. Until 2007, while the supporting technology was being refined, securities trading was constrained by human limits. Now, the only constraint is the rate at which an electronic signal can be sent and received between the data centers of a stock exchange.

Until 2002, HFT trading comprised 10% of all equity trades in the U.S. By 2010, the volume rose to 56%. Increasingly, HFT plays a role in the modern stock market. Why?

Velocity and Volume.

What makes HFT special and how does it work?
The idea behind HFT is simple: trade as much as fast as possible at small profit margins per transaction, and rely on sheer trade volume and velocity to accumulate large profits.

Economics considers a market to be any place, whether virtual or physical, where buyers and sellers of a good or service meet to trade. A stock market is like any other market, yet what is traded on a stock market makes it unique. In essence, stock markets facilitate an exchange between individuals who wish to buy or sell a ‘security’. A security is any financial instrument that has monetary value that can be traded. A security can be as basic as equity stocks that represent ownership of a public company such as Apple, or more complex instruments, such as options and futures. The way these are bought and sold stays the same.

When someone wishes to sell or buy a security they send out a public offer onto a stock market. This public information circulates within the stock market and matches the bidder’s “ask” price – that is the price at which one is willing to sell, with a buyer’s “bid price”, which is the price a buyer is willing to pay. These public bid-ask offers rush between the data centers of stock exchanges, and act as signals to the market for traders to react.

Here is what makes HFT unique. HFT programs respond to these signals faster than any other computer because they get the information first. These mere milliseconds, microseconds, and nanoseconds required to react represent a lifetime on the stock market. With this, HFT algorithms secure the trades before other traders have the opportunity to react. So fast in fact, that the buy/sell offer ceases to exist before a slower computer or broker can even place a bid on one. Not because it was lost, or because the broker blinked; it ceased to exist because the trade was executed on both ends before another trader ever had the opportunity to make an offer.

Let’s break down what is really happening.

In essence, HFT traders enjoys the ability to ‘peek’ (in essence, receive) at a market signal for valuable nanoseconds before competing traders do, and in doing so, engage in trades that allow them to exploit arbitrage opportunities across markets. The principle of arbitrage is to simultaneously buy and sell the same securities in multiple markets, to take advantage of price discrepancies across markets.

This means that a security might cost $24.45 on the New York Stock Exchange (NYSE), but $24.47 on the NASDAQ. Arbitrage is to buy this security for $24.45 on the NYSE, and sell it on the NASDAQ for the standard price of $24.47. The difference in the price of what you buy in one market and sell in another now becomes your profit margin.

In theory, such arbitrage opportunities should not exist within efficient capital markets because the price difference self corrects almost instantly. The reason for this is simple economics: if the demand for the security at $24.45 rises rapidly, the newly generated demand raises price and ‘bridges’ the arbitrage opportunity. In reality, arbitrage opportunities only exist for split seconds which are inaccessible to the average trader. For high frequency traders however, this is a different story; their microsecond advantage now becomes incredibly valuable. 

Economic intuition would suggest that even across markets trades must be almost equal in spread, and so an HFT trader cannot be making that much money for simply trading on arbitrage. Right?

Not quite. While the profit margin per trade is frequently small, the sheer volume of these trades’ amounts to substantial profits. This is best illustrated with an example.

Buy: 5.00
Sell: 5.01

Trade a million shares at a 0.01 margin. This yields $10,000 in profits. Repeat.

If that seems unreasonable, remember alone on the NYSE, on average, 6.29 billion securities were exchanged per day in 2017. Due to a low bid-ask spread these trades occur without much difficulty, known as liquidity, which amplifies the velocity. Trade velocity gives way to volume, which ultimately results in the rapid generation of profits that make HFT the lucrative business it is.

Editing by Isabel Lihotzky