Technological
innovations have had such a tremendous impact on all of our lives over the last
few decades, I often wonder; do people ever stop to appreciate how far we have come?
Already, my smartphone has become a mandatory tool in maintaining my connectivity
with the world, that the very thought of having my battery die short makes me want
to cry. Yet just 5 years ago, many of my friends (myself included), were very
content with a clamshell as long as it could text, and play a slew of fun
polyphonic ringtones. And I will be the first to admit that I laughed when Steve
Jobs introduced the iPad back in 2010, thinking the last thing the world needed
was an oversized iPhone. I would have never guessed the devastation I would
come to face 3 years later when some punk stole my iPad 2 right from under my
nose at a Starbucks (seriously watch your stuff next time). However, despite
the leaps and bounds technology has had on consumers, it has also had a
tremendous impact on the financial industry as well. Rendering what was once
reserved for a PHD graduate, a trusty HP 12c calculator, and a fun filled
afternoon on a trading desk, into soulless server that can shoot off trades quicker than
the speed of sound. Welcome to the world of high-frequency trading.
So what exactly is it?
High-frequency
trading, or HFT, consists of ultra-high speed security trades automated through
an algorithm (algos to for the tech savvy) designed to follow a particular
investing strategy. An HFT trader has the capacity to take on a wide range of
positions within fractions of a second, bringing with it the capacity to turn a
quick profit, eons ahead of any traditional market maker. Typically, these
millisecond transactions work off of very small profit margins, but when they are
run on a bulk basis, it makes the practice potentially lucrative.
The history behind
high-frequency trading can be traced back to at least 1998, when the SEC first
authorized electronic exchanges to compete in the market, enabling anyone with
basic computer and internet access the chance to participate in marketplaces
like the NYSE. Fast forward to about 2009 and add a few different iterations of
HFT models, and you’ve got a 164% jump in daily volume on the NYSE thanks to
the financial industries newfound love for HFT trades. Today, the practice has lost much of its
accelerated growth and popularity, but HFT’s still account for a quarter of
trades in the Canadian equity market, and just around half of trades in the U.S
market.
What are some of the
strategies?
Well aside from the
traditional arbitrage opportunities we always read about in text books (i.e. Foreign
exchange rate, FRA, or even exchange mispricings just to name a few), some of
the other popular strategies used in high-frequency trading include the
following:
-
Index fund
rebalancing
o
Many
mutual funds and ETF’s replicate particular indices (aka index funds) which
require frequent rebalancing and adjustments in order to stay aligned.
High-frequency traders utilize algos that can anticipate a stock price increase
caused by block orders from large institutions rebalancing or adjusting their
index funds, and exploit their speed to purchase securities ahead of the market.
-
News-Based
trading
o
A news-based
trading strategy involves algos which scan news feeds for key words and general
market sentiments to predict increases in prices for various securities, and
once again utilize their speed to buy and sell to slower market participant
-
Low-Latency
strategies
o
These
strategies involve using faster and more efficient technologies (I.e. microwave
technology has a faster response time when traveling great distances vs. fiber
optic cables) to beat out slower market participants (including other HFTs) in
any one market strategy.
So what’s the downside?
 |
| Stamen visualization of one minute of bids and offers on March 8, 2011. |
To be honest it really
depends which side of the fence you stand on. Many advocates see high-frequency
trading as a means of: increasing market liquidity (smaller bid-ask spreads and
higher trading volume), decreasing price volatility, improving market
resilience (shown to improve mini crash recovery), and increasing price
efficiency (shorter pricing anomalies due to lightning quick arbitrageurs). On
the other side many individuals criticize high frequency trading for: removing
many traditional market makers from the industry, creating additional credit
risk (difficult to monitor and control leveraged positions), and its
potentially devastating market impacts due to system failures or infrastructure
glitches. Glitches have been the main attributable force behind some of the
more recent high profile problems with high frequency trading such as:
Facebook’s IPO, the Flash Crash 2010, and Knight Capital’s $389M loss back in
2012. This has led to increased pressure on many regulatory boards to step up,
and enforce stronger compliancy and standards for this segment of the industry.
Well, despite the heat
from many recent events, it is sufficient to say that like or hate it, high
frequency trading is here to stay (at least until the next evolution in trading
happens, but who knows how long that could take). I guess the real questions we
should start asking ourselves is, is it too late to learn how to code?
Until next time, I remain your friendly neighborhood blogger,
Jon
No comments:
Post a Comment