What is high frequency trading?

High frequency trading is a form of scalping taken to the extreme. Positions are taken by trading robots which make a multitude of trips back and forth on the financial markets to take advantage of very small price differences. To give you an idea, high frequency trading makes it possible to exceed 1000 transactions per second and technologies are constantly evolving to improve this extraordinary performance.

High frequency trading algorithms

Humans are obviously not capable of carrying out so many transactions per second. High frequency trading is based on very powerful trading algorithms. These algorithms are developed by services dedicated to their development in large banks. High-frequency trading algorithms are constantly evolving t adapt to new market conditions.

However, an algorithm is not enough. Banks are in fact competing in high-frequency trading and the reaction time of the algorithm to place the transaction is a major element in generating performance. The lower the reaction time, the greater the performance. This time is measured in milliseconds.

To save precious milliseconds, the servers on which the high-frequency trading algorithms are hosted are positioned as close as possible to the stock exchanges. Thus, coupled with a very high-speed internet connection, the purchase and sale order is transmitted more quickly to the market. This is what allows high frequency trading to generate profits.

Effects of high frequency trading on your trading

According to TABB group, which is an international research and consulting firm focused exclusively on capital markets, high frequency trading represents between 25/30% of orders placed on the equity market in Europe and 70% in the United States! The stock market is not the only one impacted as shown by this graph indicating the percentage of assets impacted by high-frequency trading:

As we can see, high-frequency trading is also very present in the futures and options market . There is still little development on bonds on the Forex (foreign exchange market).

High frequency trading has several effects on your trading:

– Increased volatility: The multiplication of the number of transactions creates volatility. Price variations are more numerous and false trend movements are created without justification. How many times have you noticed that market movements make no sense? In many cases, the culprit is high-frequency trading, although we should not attribute all the volatility on the stock markets to it either.

– Pollution of the order book : I spoke to you above about the figures for high frequency trading but they only concern transactions. However, not all stock market orders are executed. It is estimated that in Europe, more than 50% of orders transmitted to the market come from high-frequency trading algorithms. In the United States, the figure even exceeds 80%… For those who practice scalping, this can therefore distort decision-making.

– Risk of mini flash crashes: Due to lack of control over certain trading algorithms or human error, high frequency trading sometimes causes flash crashes. This was the case on May 6, 2010 when the Dow Jones index lost nearly 10% for no apparent reason before retracing a large part of the decline in the minutes that followed. Here is the graph showing this crash:

This was a side effect of high frequency trading. In certain very specific market conditions, algorithms can cause a chain reaction that leads to a mini crash. Although high-frequency trading is under surveillance by regulatory authorities (the AMF in France), they seem powerless in the face of this practice and its effects on the stock markets.