High frequency trading (NAF), better known by its English name High Frecuency Trading (HFT), is a type of trading that takes place in financial markets using powerful computers and automated algorithms. Its main virtue is the processing speed , which allows operations to be carried out in a fraction of a second. Its objective is to capture a fraction of a cent in each trade in the short term. NAFs use little leverage (leverage), and neither do they accumulate positions. At the limit, they keep them overnight.
When we talk about NAF, we are talking about volatility and the correlation of global markets . The latest estimate of turnover predicts that transactions on exchanges conducted by NAF in the United States is 65% of transactions, while in Europe it is lower (around 40%).
How does a NAF work?
The operation of a NAF is based on computers that buy and sell shares at breakneck speed. In some markets, like Nasdaq, it allows some traders to see the command stack 30 milliseconds before showing it to the rest.
This allows them to take advantage by knowing what the most immediate demand will be. Cents are earned for each NAF operation, however this operation is performed millions of times a day. In the next photo we see one of the strategies used by NAF companies.
Another example of company practices that use NAF:
Imagine an asset that is listed on different stock exchanges (NYSE, Tourquoise and Chix). When an order arrives at ChiX that is executed at a price (and remains incomplete), the NAF algorithms assume that the same order will eventually be completed on another platform such as Turquoise or NYSE. It is at this very moment that NAF «places itself in the middle» in anticipation of buying the shares on another platform and placing a sales order shortly before the arrival of the initial order, which it will inevitably buy at the purchase price of the NAF offer. NAF takes a minimal difference.
NAF has the necessary power to receive the order when it reaches ChiX and to transmit these same orders to the other markets , giving strong consideration to buy or sell, which will eventually happen.
In order to avoid getting hurt from this operation, major investors try to program their systems so that their orders arrive at the same time in all markets, thus preventing NAF from benefiting from the latency of orders.
NAF is supposed to only have order information when it reaches a market, otherwise an illegal practice known as «front running» would not be incurring.
Some of the most popular strategies when operating with NAF are as follows :
- saturation technique : it consists of a series of companies (NAF) detecting that the market will receive an order to buy shares from an investor, then send consecutive stock purchase orders at a certain price so that, soon then they can sell them a few cents above before an investor’s initial order is executed. Thus, only those who operate faster will benefit from this price difference. That is, they are ahead of market orders and place them at a slightly higher price.
- interference technique : consists of sending an order and the same millisecond to delete that order. It is a way to control the stock market, with orders that are rarely executed. This strategy aims to induce participants to error.
- Disappointment technique : It consists of pretending to buy shares, launching market orders, but the final intention is to sell (and vice versa). .
Difference between latency and speed
The speed is measured in space / time, while the latency is the time from which the order is transmitted until it is executed. Latency takes into account the “traffic lights”, the various intermediaries through which the order passes, until reaching its destination.
History of NAF
On May 6, 2010, the Stock Exchange on Wall Street collapsed at high speed, following an unprecedented scheme . It was thought that this possible fall of the stock market (flash crash) had its origin in the Greek crisis. The austerity measures taken by the Greek government had caused several disturbances in the country (reaching the death of two people) both the financial and political plan in Greece were equally terrible.
But where the shock did not come from the European country. The American pension fund US Wandell & Reed sold 75,000 contracts at an incredible rate, as if it wanted to get rid of those bonds. This alone could not destabilize the market, all NAF companies became infected with the fear generated and started selling to the microsecond.
The debacle lasted no more than 14 minutes. The Chicago Stock Exchange had its collapse interrupting the shares for 5 seconds, it was a warning from the market indicating how far a stock market collapse can occur with this type of practice. This phenomenon, in which the stock market plunges at breakneck speed, is known as a sudden drop.
Companies working with NAF
Companies working with NAF use short and wide simultaneously , placing limited orders at a market price slightly above or below as a sale or purchase. Thus, they get a sure benefit from the price difference and for that, they need the time to market to be immediate. They are experts in statistical arbitrage, looking for price discrepancies between the values of different asset classes.
NAF operations act as market makers by creating supply and demand.
Some of the traders who trade the most in NAF strategies are Knight Capital Group, LLC Getco, Citadel LLC, Saltar Trading, LLC, Goldman Sachs and Virtu.
The FBI opened an investigation of NAF companies for committing the insider crime. I investigated the links between high-speed traders and major stock exchanges, examining whether companies are receiving preferential treatment that puts other investors at a disadvantage. For the FBI, the investigation is a new way to use inside information; the velocity. Market patterns are sought that can reveal whether any commercial activity has violated the law. They will have to demonstrate that these operations were carried out with fraudulent intent, which is much more complicated.
NAF affects large investors or large orders at low illiquid values.
In 2014, the broker Degiro conducted a study testing the SOR (system whose purpose is to reduce transaction costs for the final investor) used to send orders to different European stock exchanges. Noting that NAF companies are active in European markets, the Dutch platform produced a report and found evidence that traders using high-frequency trading benefit from this order path at the expense of large investors or large orders at low liquid values .
The broker said his analysis is in line with the ideas reflected in Michael Lewis’s book, «Flash Boys: A Wall Street Uprising,» which says high-frequency traders take advantage of the speed of their systems, which give them milliseconds of advantage to overtake small investors in order execution .