High-frequency trading is a type of algorithmic trading in which large volumes of financial instruments are bought and sold automatically at very high speeds. It is secretive and mysterious, but not at all evil. It makes the stock market more efficient and helps small investors who trade at random times over the day. High-frequency trading involves billions of trades where the goal is to make just a few or even fractions of cents per trade. It’s a game of mind-boggling speed and information, where stocks are bought and sold in less than a second. However, it’s also a game where only high-frequency traders know the rules and have the ability to play with concealed cards, whereas investors play with their cards face up. Millions and millions of dollars are spent by HFT companies to save just a few milliseconds. High-frequency trading is ultimately all about speed.
High-frequency trading (HFT) is very complex and is ever-changing, which means it is both hard to stop and quantify. Valuable information is asymmetric in the stock market and the HFT companies work on capitalizing this asymmetry at the expense of the investors.
The following example will make it much clear how HFT works.
Assuming that one share of Emaar Properties is at the bid price of AED 4.90. This means that someone is willing to pay AED 4.90 for one share of Emaar. While the asking price is AED 5. In other words, the ‘ask price’ is what someone’s willing to sell a share of Emaar for. So, now you want to buy 50 shares of Emaar at the best possible price (AED 5) but after you type in your market order, you realize that the best-offered price and the price you settled at were AED 5.10. Ring any bells? How did that happen? The answer is “High-Frequency Trading”.
Although the latency or the time period between the placement of an order and its execution was less than a second, a lot of things happened in between. First off, the stockbroker has sold the information of your order to a high-frequency trading company. Knowing that you wanted to buy 50 shares at AED 5, the HFT Company quickly (measures in 1,000th of a second) buys 50 shares at AED 5, before you, and places a sales order at $100.01, which was the price you bought at. In other words, you paid 50*AED 0.10 = AED 5 more than you were supposed to, and the HFT company grabbed that profit without any risk.
This might both seem outrageous and wrong (and it is!). Nevertheless, it is legal and is just one of the many possible ways HFT companies use to exploit the stock market on a daily basis. HFT can make investing appear like you’re placing bets with a bookmaker who already knows the score of the game played! A common denominator for these two strategies mentioned above and for the many more HFT strategies is that contrary to the stock investor, the HFT Companies have no position when the stock market closes and is therefore neither playing the same game or is exposed to the same kind of risk. It’s all buying and selling at the expense of investors.
One thing to remember though is that HFT companies compete with each other, and not with the long-term investor. The very essence of a stock market has always been in buying a piece of a real business, and that fact has not changed with the rise of HFT. As an investor, there will be times where you will be paying marginally more, or getting marginally less for your stocks, but it won’t affect the overall performance of your portfolio very much. On the other hand, you should be concerned about the general instability of the financial markets, and be frustrated about financing a party thrown by an HFT Company where they aren’t invited.
To the best of the investors’ knowledge, there are no billionaires that have solely used technical analysis. Basically, HFT Companies use some of these techniques in their algorithms. The problem with competing with them as a private investor is that you don’t have the same resources in terms of speed and information as they have. Another fundamental difference is that private investors spend a much higher amount on each stock trade, requiring them to predict the market extremely well over time. HFT companies, on the other hand, are structured so that they can be highly profitable by selling and buying at fractions of a cent or even at the very same price.
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