What actually happens behind the closed doors of a high frequency trading firm? HFT firms have this mystifying demeanor that both the general public and trading community seem to be fascinated by. Aside from a book focusing on the morality of high frequency trading, the general population does not have a good resource for what these firms do or the purpose they serve.
“The firms and individuals complaining about HFTs are those who are refusing to upgrade their technology”. This is what one HFT equity trader had to say in response to Michael Lewis’s Flash Boys. There is no question that the computer has always been a trader’s best friend. Paul Tudor Jones used charting tools to overlay the 1929 crash chart onto a pre-1987 crash chart to predict the market collapse. Mark D. Cook built an algorithm based off of the tick count to produce multiple triple-digit return years. The question is, why do HFTs draw so much heat from the media and public for employing the newest technology when traders have been doing this since the punch card machine?
The answer lies in human nature. We are preprogramed to resist change and the use of ultra fast execution and a completely new view of how to trade the markets is this exact kind of resistance prone innovation. The reality is that HFTs share many similarities with a mechanical trader. The main difference is in the execution of the strategy. “I don’t execute any trades, we leave that to the computer. I design the strategy and monitor the algorithm to make sure it’s behaving as we would expect.” Any trader knows that execution can sometimes make or break a trade. By leaving the execution to a computer, the strategy is followed exactly how it is designed.
One of the most common complaints about high frequency trading is the use of false orders or bait trades. Traders put in an order to buy stock only to see the liquidity disappear or get a partial fill. This practice has been around long before HFTs. Purchasing a stock is a negotiation with the market. If trader A sees that trader B is willing to buy at a certain price, trader A will push his price up until trader B will not buy any more shares. HFTs simply take this age-old practice and speed it up, exponentially. This allows the market to reach an equilibrium price much quicker than before.
Just because a firm is employing a HFT strategy does not guarantee profitability. “We just trade equities because that is where we have our edge. We have tried options, futures, and other products but we could not find an edge”. HFT firms are not above the market. They are subject to the demands of the market for a trader to be profitable. At the end of the day, high frequency trading is just another approach to the market.
Where HFTs do have a significant edge over the rest of the trading community and where mechanical traders need to adapt is in their execution. “We built our execution platform in-house to fit our strategies needs, plus we save on commission and brokerage fees. We do not hire Ivy League students to build these platforms because it’s not necessary. Instead we hire strong programmers and teach them what they need to know about the market and our strategy.”
“High frequency trading is here to stay.
By providing liquidity and quicker price discovery, HFTs serve a valuable market function.” The general public and trading community must accept these realities and adapt. The general public will always criticize trading practices, but their acceptance of HFT strategies and technology will come in time. Just as traders had to adapt from floor based trading to computerized trading, they must adapt from human execution to computerized execution. The need to switch is not immediately pressing, but those who are quick to adapt are often rewarded.