Introduction
Imagine walking into an active stock exchange, with trades occurring faster than you can blink. This is high-frequency trading (HFT), a unique component of financial markets that offers advantages and disadvantages and has changed the face of investments as we know them. As an investor, you may be thinking about how this new type of trading affects your portfolio, or even the stock market in general. In this article, we will define what HFT is, how it works, and what it means to you while discussing HFT's function in India's financial markets.
What is High-Frequency Trading?
High-frequency trading (HFT) utilises computer programs that execute trades and algorithms that allow the program to generate thousands (or more) trades of financial instruments in microseconds. HFT does not entail following traditional trading rules and trading older-style instruments and methods; instead, it is not unusual not to even pull up a price chart. Whereas other traders analyse price charts for hours and days to interpret market moves, HFT sells minor price differences across financial instruments: stocks, futures, etc. and does so in massive volumes.
HFT is not about speculating on long-term market trends. It is about seizing opportunities that only last seconds or minutes, such as discrepancies in the market price between exchanges or assets. While HFT isn't directly accessible to retail investors, its presence improves market liquidity and narrows bid-ask spreads, indirectly benefiting your trading experience.
How Does HFT Work?
Think about how you would buy a stock at the lowest price. Now think of a computer doing this thousands of times a second, with precision you could never come close to matching. This is HFT.
Here is how it works:
1. Data is pulled in real time using high-frequency trading software. The software consistently pulls data about the market from the exchange. It displays critical information such as stock prices, order books, and other trade volume requests from exchanges like the National Stock Exchange (NSE).
2. The data is crunched and parsed in microseconds, identifying opportunities such as the price from NSE and comparing it to the price at the Bombay Stock Exchange (BSE) or mis-priced stocks.
3. Once an opportunity is detected, the system will place a trade using high-speed trading infrastructure to ensure no latency or delays. It is often configured to ensure minimal latency, as the system typically co-locates facilities where the trading servers are also located, which minimises further delays.
4. If the price changes, many HFT orders are simply cancelled to guarantee only profitable trades get executed. The nature of HFT is to make many near-instantaneous trades for placing and cancelling.
5. Extremely sophisticated systems ensure they trade only within the parameters set by their regulatory body, the Securities and Exchange Board of India (SEBI) in India, to prevent making mistakes that could harm most of the market.
The high-frequency trading process relies on advanced software and hardware, such as Field-Programmable Gate Arrays (FPGAs), which can process information faster than conventional computers. That means HFT firms can react and place orders before you see them on your trading app.
What is the importance of HFT to you?
HFT fundamentally alters the trading experience you have in many ways:
Increased Liquidity: HFT firms act as market makers by placing orders to buy and sell a financial instrument, and they sometimes continuously buy and sell the same financial instrument. This allows you to trade easily without any price fluctuation in the financial instrument.
Lower Prices: HFT decreases the difference between the buy and sell prices, reducing overall trading costs on trading platforms.
Faster Markets: Prices will incorporate new information in real time, ensuring people trade financial instruments at fair prices based on the most recent information.
However, high-frequency trading does have risks. Glitches in algorithms can cause steep drops in pricing, like what occurred globally in 2010 in the Flash Crash. In India, SEBI pays attention to high-frequency trading when it comes to market manipulation. SEBI works closely with high-frequency trading firms, monitoring their respective compliance with rules on algorithm approval and risk management practices.
What is the future of HFT in India?
As the number of exchanges and services, such as NSE co-location service, continues to increase, high-frequency trading and algorithmic trading will certainly expand, and it is becoming a lot smarter as companies are incorporating AI into the operational side and predicting movement in the market. As an investor, having real-time knowledge will help you know why market moves occur and understanding it will help you make sensible decisions.
In summary, high-frequency trading (HFT) is an ultra-fast, technology-based trading style currently defining the modern marketplace. It provides benefits that include liquidity and reduced costs, but it also raises questions around fairness. By understanding HFT, you will have the confidence to trade in India's marketplace and be aware of the forces behind the prices you see on the screen.
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