High-Frequency Trading (HFT) explained – The war between man and machine that extracts $billions from the market

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Intro

HFT uses custom-built machines to buy or sell the assets you want before you can – then sell you those same assets for a profit. They are the potentially unnecessary middle-man charging a hidden tax by beating humans to the market.

What’s HFT?

HFT is a subset of algorithmic trading that specializes in scale and speed. HFT can potentially execute 1000s of trades in the time it takes a human trader to blink. The fastest firms can reach speeds of sub-16 microseconds (16 millionths of a second) per trade.

Speed (Latency) Advantage

HFT exists to be first. Mostly it takes advantage of arbitrage (buying on one exchange and selling to another at a higher price). It also detects orders placed by other traders taking a share of their profits by capitalizing on the market movement.

Pay for Speed

HFT firms spend millions to reduce latency, building infrastructures like cables and microwave towers. Spread famously built a secret underground cable from New York to Chicago for $300 mil just to cut transfer speed by 3 milliseconds

Data or Nothing

HFT’s algorithms are fed by info either from exchange price data feeds or more obscure sources. Without data, the machines don’t know what to buy or sell. Data is what makes HFT’s speed valuable and HFT firms will do seemingly anything to get it.

Getting Data First

For HFT firms it’s not enough to get the data, they need to get it and act on it before anyone else.

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Reuters famously got caught selling access to the consumer confidence number to HFT firms minutes before public release.

Dark Pools

Dark Pools, exchanges owned by banks and hidden from the public, exist in theory to limit the impact of big orders on the market. Some HFT firms get special access to data on trades happening inside, which they use to anticipate price movements on other exchanges.

Rebates

Rebates are incentives typically paid to a seller by an exchange to encourage liquidity. HFT firms convinced some exchanges to pay buyers instead. This encourages traders to use these exchanges first giving HFT firms the tip of which assets to buy on other markets.

Regulation

In the US, brokers are required to buy stocks at the lowest market price – this is supposed to make markets fairer. It also means HFT firms know where to look when another trader is looking to buy and they can use that information to beat them to the next market.

Pinging

If you want to know if people want to buy or sell you may need to do a little trading yourself. HFT firms send small orders to exchanges. If they’re filled instantly they infer bigger orders are coming & use their speed to get to the other markets first.

Quantity

Over Quality HFT impact seems insignificant taking as little as 0.0005USD per-share profit. But multiplied by the millions of trades HFT can execute in a day the impact can be huge In 2008, HFT made an estimated 8-20 billion USD net profit!

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Hidden Tax or Necessary Evil?

Some argue HFT is essential to healthy liquidity in the market. Others claim HFT skims money from transactions that likely would have happened anyway. As with most things, the answer is probably somewhere in the middle.

Harmony

HFT machines will always have a speed advantage over their human counterparts. But man and machine can co-exist. As long as we can find system solutions that remove informational advantages for HFT firms to skim the profits of regular traders.

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