Explaining High-Frequency Trading: Why Everybody Wants It Gone
The most profitable but most immoral way to trade
High-Frequency Trading (HFT) is something that has been talked about on every news channel you’ve probably watched. In most cases, it’s a large debate between somebody who supports the idea (and likely owns a High-Frequency Trading setup) and somebody who is completely against it.
The most common argument you will hear from these shows is that the person against HFT says that it’s immoral, while the person in support of HFT says that it’s not illegal.
It’s a very vague kind of argument that you’d see politicians go into so there’s not much one can take away from it.
In order to truly understand what HFT really is and why it needs to go as soon as possible, we need to explain how it actually works.
Explaining it with industry-standard terms and definitions is going to be a bit more challenging, so let’s try and explain it through an easy-to-understand example.
Before we move to the example, let’s define the three crucial features of running an HFT system.
3 main aspects of an HFT rig
There are two things that HFT most definitely is, profitable and expensive. Not everybody has what it takes to have a fully functioning HFT rig nowadays, simply because there’s either no space left, or it’s just too much of a hassle. Furthermore, there’s always a chance it could become illegal.
Anyway, here are the three things people need to do, in order to profit from their HFT rig:
- A good location
- Access to institutional trades or large retail trades
- Reserve of some stocks
Let's try and explain these step by step
Why do you need a good location?
The location will determine the time your HFT setup will require to get a signal from the exchange. What this means is that if your server is close to the exchange’s server, there’s this one second difference between you and anybody else on the exchange.
That one second difference is enough to earn you millions if not billions of dollars within just a few months.
This is one of the reasons why the real estate next to exchanges is so expensive. Everybody knows that HFT users really want a location that is as close as possible.
The process of placing your server as close to the exchange as possible is called co-location, and it’s been around in the financial industry as well as any other industry for a while now. One of the best examples is when people were simply taking their laptops to a specific company’s office to get the best deals.
One such example was when a trader from South Africa applied for a job interview in one of the Forex brokers in the country. This Forex broker was about to have a big promotion announcement about a limited number of bonuses. The XM bonus promotion for South Africans was a very popular event, and ever since this one trader went through lengths to get himself in the XM office to have first dibs, it has been pretty mayhem for any Forex broker to try another promotion like that.
Why institutional and large trades?
The obvious answer to this question would be that if there are bulk orders being hijacked by HFT users, then the more money they will make. That is also a true assessment of this aspect of HFT, but there is also another crucial point.
You see, when an exchange receives a large order, it is very hard for it to fill it completely very fast. Simply because it first needs to find all of the relevant orders it can match with this first order and then process it. That could take the time or have some bugs in the future.
In order to prevent this, the exchange breaks large orders down into smaller, more manageable chunks. The trader gets maybe a three to four second delay, but the HFT user gets almost a lifetime’s worth of time to manipulate the prices.
To bring it more into light, let’s imagine that you placed a buy order for 1,000 Amazon shares. In order for the exchange to handle it as fast as possible, it will break it down to ten 100 share orders and start filling them up one by one.
This is exactly where the HFT user’s system comes into play and starts to manipulate the prices.
How HFT manipulates prices and where does it need a reserve of stocks?
Before you place the buy order for 1,000 Amazon shares, you will be asked by the exchange to indicate the maximum price you are willing to pay for each. Let’s say that the market price for an Amazon share is $50, and you say that you’re willing to pay a maximum of $55. The market will understand this order and look for Amazon shares being sold for first under $50, and then under $55.
Let’s say that your first batch of orders, meaning the first 100 shares are processed. The market sold them to you for $50 apiece. Once this is done, the market sends this information to the general notice board.
The first one to notice this notification is the HFT system. What this means is that it understand that somebody has just purchased 100 Amazon shares for the market price. Given the fact that almost everybody focuses on large trades on this exchange, it knows that there is more to come from this order, so it will start searching for the maximum price that you indicated.
What it will do is take the Amazon shares it has in reserve and try to sell them to you for $60. This will fail to go through, then it will try $59, $58, $57 and all the way down to $55 until the order processes and the share is sold.
The HFT determines that your maximum price is $55. Therefore it will take all of its reserves, and thanks to a closer location to the exchange, sell them to you for $55 apiece.
If it runs out of these shares, it will quickly buy them for less than $55 on the market, and sell them to you for $55. It will still manage to make a decent profit.
All in all, the HFT works to sell you a share for as much money as possible.
Should HFT be banned?
HFT should definitely be illegal. The co-location of a server should not be the only thing that determines success for a trader’s strategy. Almost everybody in the market loses besides the HFT user in this case.
You lose because the HFT sells you the shares for a larger price, thus decreasing your ROI, and it prevents the original seller from the ability to sell for market price, thus hindering their profits as well.
This is not just a personal opinion as well, multiple economy experts, veteran traders, exchange owners, and professionals have mentioned that HFT is one of the most immoral ways to trade. But, as long as it’s legal people will continue to do it.