New Alternatives To High Frequency Trading (HFT)
For a time, it looked as if high-frequency trading, or HFT, would take over the market completely. In 2010, HFT made up over 60% of U.S. equity volume. But the trend may be waning. In 2009, high-frequency traders moved about 3.25 billion shares a day. In 2012, it was 1.6 billion a day, according to Bloomberg. At the same time, average profits fell from “about a tenth of a penny per share to a twentieth of a penny,” the report noted.
In 2017, HFT accounted for just under half of all domestic equity volume.
In HFT, powerful computers use complex algorithms to analyze markets and execute super fast trades, usually in large volumes. HFT requires advanced trading infrastructure like powerful computers with high-end hardware costing huge amounts of money and cutting into profits. And with increasing competition, success is not guaranteed. This article looks at why traders are moving away from HFT and what alternatives strategies they are now using.
Why HFT Is Losing Ground
A HFT program costs a lot of money to establish and maintain. The powerful computer hardware and software needs frequent and costly upgrades that eat into profits. Markets are highly dynamic, and replicating everything into computer programs is impossible. The success rate in HFT is low due to errors in underlying algorithms.
The world of HFT also includes ultra-high-frequency trading. Ultra-high-frequency traders pay for access to an exchange that shows price quotes a bit earlier than the rest of the market. This extra time advantage leads the other market participants operating at a disadvantage. The situation has led to claims of unfair practices and growing opposition to HFT.
HFT regulations are also getting stricter by the day. In 2013, Italy was the first country to introduce a special tax on high-frequency trading and this was closely followed by a similar tax in France.
The HFT marketplace has also become very crowded. Individuals and professionals are pitting their smartest algorithms against each other. Participants even deploy HFT algorithms to detect and outbid other algorithms. The net result is of high-speed programs fighting against each other, squeezing wafer-thin profits even more.
Due to the above-mentioned factors of increased infrastructure and execution costs, new taxes and increased regulations, high-frequency trading profits are shrinking. Former high-frequency traders are moving toward alternative trading strategies.
Emerging Alternatives To HFT
Firms are moving toward operationally efficient, lower-cost trading strategies that do not trigger greater regulation.
- Momentum Trading: The age-old technical analysis indicator based on momentum identification is one of the popular alternatives to HFT. Momentum trading involves sensing the direction of price moves that are expected to continue for some time (anywhere from a few minutes to a few months). Once the computer algorithm senses a direction, the traders places one or multiple staggered trades with large-sized orders. Due to the large quantity of orders, even small differential price moves result in handsome profits over time. Since positions based on momentum trading need to be held onto for some time, rapid trading within milliseconds or microseconds is not necessary and saves enormously on infrastructure costs.
- Automated News-Based Trading: News drives the market. Exchanges, news agencies and data vendors make a lot of money selling dedicated news feeds to traders. Automated trades based on automatic analysis of news items has been gaining momentum. Computer programs are now able to read news items and take instant trading actions in response. For example, assume company ABC's stock is trading at $25.40 per share when the following hypothetical news items comes in: ABC declares dividend of 20 cents per share with ex-date Sept. 5, 2015. As a result, the stock price will shoot up by the same amount of the dividend (20 cents) to around $25.60. The computer program identifies keywords like dividend, the amount of the dividend and the date and places an instant trade order. It should be programed to purchase ABC stocks only to the limited (expected) price hike of $25.60. This news-based strategy can work better than HFTs as those orders are to be sent in split second, mostly on open market price quotes and may get executed at unfavorable prices. Beyond dividends, news-based automated trading is programed for project bidding results, company quarterly results, other corporate actions like stock splits and changes in forex rates for companies having high foreign exposure.