What is high Frequency Trading ?

In electronic financial markets algorithmic trading or automated trading, also

known as high-frequency trading is the use of computer programs for entering
trading orders with the computer algorithm deciding on aspects of the order such
as the timing, price, or quantity of the order, or in many cases initiating the order
without human intervention.These Powerful algorithms execute millions of
orders a second and scan dozens of public and private marketplaces
simultaneously. They can spot trends before other investors can blink, changing
orders and strategies within milliseconds. [3,7]

High-frequency traders often confound other investors by issuing and then

canceling orders almost simultaneously. Loopholes in market rules give high-
speed investors an early glance at how others are trading. And their computers
can essentially bully slower investors into giving up profits and then disappear
before anyone even knows they were there. High-frequency traders also benefit
from competition among the various exchanges, which pay small fees that are
often collected by the biggest and most active traders typically a quarter of a cent
per share to whoever arrives first. Those small payments, spread over millions of
shares, help high-speed investors profit simply by trading enormous numbers of
shares, even if they buy or sell at a modest loss. high-frequency trading is widely
used by pension funds, mutual funds, and other buy side (investor driven)
institutional traders, to divide large trades into several smaller trades in order to
manage market impact, and risk. [4]

How does high frequency trading work ?

To understand High frequency Trading let’s examine when slow moving every
day traders such as the general public sitting at home on their pc go up against
these high frequency computers running these pre-set algorithms. It turns out to
be a slaughter just like when the hump back whales open its enormous mouths to
feed and suck up every little fish in sight.
It was July 15, and intel the computer chip giant, had reporting robust earnings
the night before. Some investors, smelling opportunity, set out to buy shares in
the semiconductor company Broadcom. (Their activities were described by an
investor at a major Wall Street firm who spoke on the condition of anonymity to
protect his job.) The slower traders faced a quandary: If they sought to buy a
large number of shares at once, they would tip their hand and risk driving up
Broadcom’s price. So, as is often the case on Wall Street, they divided their orders
into dozens of small batches, hoping to cover their tracks. One second after the
market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all
potential sellers at the same time, some of those orders were most likely routed to
a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds —
in what are known as flash orders. While markets are supposed to ensure
transparency by showing orders to everyone simultaneously, a loophole in
regulations allows marketplaces like Nasdaq to show traders some orders ahead
of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the
hunger for Broadcom was growing. Their computers began buying up Broadcom
shares and then reselling them to the slower investors at higher prices. The
overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software

went into high gear. Automatic programs began issuing and canceling tiny orders
within milliseconds to determine how much the slower traders were willing to
pay. The high-frequency computers quickly determined that some investors’
upper limit was $26.40. The price shot to $26.39, and high-frequency programs
began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000
shares, or $7,800 more than if they had been able to move as quickly as the high-
frequency traders.

Multiply such trades across thousands of stocks a day, and the profits are
substantial. High-frequency traders generated about $21 billion in profits last
year, the Tabb Group, a research firm, estimates. [2,6]
Who are the big players in high frequency?

They range from well- to lesser-known firms. Goldman Sachs Group Inc. and
Chicago hedge fund Citadel Investment Group LLC have high-frequency
operations. An innovator in superfast trading strategies is hedge-fund firm
Renaissance Technologies LLC.Privately held Getco LLC, a Chicago high-
frequency firm founded in 1999, is a registered market maker with operations in
markets around the world. Other high-frequency outfits include firms such as
Jane Street Capital LLC, Hudson River Trading LLC, Wolverine Trading LLC and
Jump Trading LLC. The main tactics used by these major players are arbitrage
and benchmarking strategies.[7]

Arbitrage

A classical arbitrage strategy might involve three or four securities such as

covered interest rate parity in the foreign exchange market which gives a relation
between the prices of a domestic bond, a bond denominated in a foreign
currency, the spot price of the currency, and the price of a forward contract on
the currency. If the market prices are sufficiently different from those implied in
the model to cover transactions cost then four transactions can be made to
guarantee a risk-free profit. Algorithmic trading allows similar arbitrages using
models of greater complexity involving many more than 4 securities. The TABB
Group estimates that annual aggregate profits of low latency arbitrage strategies
currently exceed US$21 billion.[1,7]

benchmarking

A "benchmarking" algorithm is used by traders attempting to mimic an index's

return.Any type of algo trading which depends on the programming skills of
other algo traders is called "gaming". Dark pools are alternative electronic stock
exchanges where trading takes place anonymously, with most orders hidden or
"iceberged." Gamers or "sharks" sniff out large orders by "pinging" small market
orders to buy and sell. When several small orders are filled the sharks may have
discovered the presence of a large iceberged order. They then front run the
order."They look for big, dumb elephants leaving big footprints," said Joe Saluzzi,
head of equity trading at Themis Trading.... "If you're getting tapped by odd lots,
if it happens 40 times...you're being gamed."Any sort of pattern recognition or
predictive model can be used to initiate algo trading. Neural networks and
genetic programming have been used to create these models.“Now it’s an arms
race,” said Andrew Lo, director of the Massachusetts Institute of Technology’s
Laboratory for Financial Engineering. “Everyone is building more sophisticated
algorithms, and the more competition exists, the smaller the profits.The arms
race has allegedly included stealing computer code. UBS has sued three of its
former traders and Jefferies & Company for stealing algorithmic trading
programs.[8]

Effects of this high frequency trading on the market

Though its development may have been prompted by decreasing trade sizes
caused by decimalization, algorithmic trading has reduced trade sizes further.
Jobs once done by human traders are being switched to computers. The speeds of
computer connections, measured in milliseconds and even microseconds, have
become very important.[5]

More fully automated markets such as NASDAQ, Direct Edge and BATS, in the
US, have gained market share from less automated markets such as the NYSE.
Economies of scale in electronic trading have contributed to lowering
commissions and trade processing fees, and contributed to international mergers
and consolidation of financial exchanges.[5]

Competition is developing among exchanges for the fastest processing times for
completing trades. For example the London Stock Exchange, in June 2007,
started a new system called TradElect, which promises an average 10 millisecond
turnaround time from placing an order to final confirmation, and can process
3,000 orders per second. This speed would already be considered a quaint
benchmark as competitive exchanges now offer 3 millisecond turnaround times
in the US.This is of great importance to high frequency traders, because they have
to attempt to pinpoint the consistent and probable performance ranges of given
financial instruments. These professionals are often dealing in versions of stock
index funds like the E-mini S&Ps because they seek consistency and risk-
mitigation along with top performance. They must filter market data to work into
their software programming so that there is the lowest latency and highest
liquidity at the time for placing stop-losses and/or taking profits. With high
volatility in these markets, this becomes a complex and potentially nerve-
wracking endeavor, where a small mistake can lead to a large loss. Absolute
frequency data play into the development of the trader's pre-programmed
instructions

Spending on computers and software in the financial industry increased to $26.4

billion in 2005.[1,5]
 Sources
1. High-Frequency Trading, Wikinvest
2. Artificial intelligence applied heavily to picking stocks by Charles Duhigg, November
23, 2006
3. Wikipedia webpage <http://en.wikipedia.org/wiki/Algorithmic_trading>
4. Cracking The Street's New Math, Algorithmic trades are sweeping the stock market by
Mara Der Hovanesian April 18, 2005
http://www.businessweek.com/magazine/content/05_16/b3929113_mz020.htm>
5. Geoffrey Rogow, Rise of the (Market) Machines, The Wall Street Journal, June 19, 2009
6. "If you're reading this, it's too late: a machine got here first," The Financial Times, April
16, 2007, p.1 http://www.ft.com/cms/s/bb570626-ebb6-11db-b290-
000b5df10621,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com
%2Fcms%2Fs%2F0%2Fbb570626-ebb6-11db-b290-000b5df10621.html
%3Fnclick_check%3D1&_i_referer=&nclick_check=1
7. What’s behind the High-Frequency trading, The Wall Street Journal, August 1, 2009
http://online.wsj.com/article/SB124908601669298293.html
8. Carney, John (June 26, 2009). "UBS Accuses Three Quant Traders Of Stealing Its Secret
Code". The Business Insider. http://www.businessinsider.com/ubs-accuses-three-quant-
traders-of-stealing-its-secret-code-2009-6. Retrieved July 14, 2009.