Understanding High Frequency Trading (HFT)

Many have read the book “Flash Boys” by Michael Lewis, which gives the reader an insider’s view into the murky world of High Frequency Trading, more commonly known as HFT (and if you haven’t, I highly suggest that you do!). Here, I’ll try to break down what HFT is, how it works, and its prevalence on the India’s capital markets today.

It’s a Speed Game

HFT, on its own, is exactly what the name suggests- extremely fast, high frequency trades. Instead of placing a trade per second, High Frequency Trading firms have reached a point where they can place multiple trades within nanoseconds. Not milliseconds (1/1000th of a second) or microseconds (1 millionth of a second), but nanoseconds- that is, 1 billionth of a second.

So how does one do High Frequency Trading? Well, as it stands now, it’s not quite that easy to do high frequency trading. Typically, it involves the following.

1. Co-location: HFT firms try to deploy their servers (basically super fast computers) as close to an exchange as possible. The method they do this is by having their servers co-located at the exchange.Each exchange typically has a collocation center, including the NSE and BSE. Firms rent out space for their servers in order to get their servers into the exchange’s collocation “rack”. This gives them an advantage over regular traders who are not as close to the exchange.
2. Algorithms: HFT firms deploy algorithms that are pre-programmed by extremely smart (and well paid!) programmers who understand the markets and look for strategies to deploy in a high frequency fashion.There are all sorts of algorithms that HFT uses, including market making, statistical arbitrage, news trading, or to put it even more simple- any strategy that the programmer finds profitable. Due to the fact that the firm is getting market data faster than non HFT players and can send orders faster than non HFT players, HFT algorithms will be able to beat a non HFT algorithm any day of the week. In a nutshell, if the strategy can be coded, it can be programmed arithmetically and the HFT firm has an automatic edge.

   Let’s take an example. Suppose the Reserve Bank of India announces a GDP figure that beats analyst expectations by a huge amount. All traders are expecting the markets to go up. HFT firms will be able to process that information and fire off trades within nanoseconds, grabbing the lowest market price before others get to it. By the time the human, sitting in front of his terminal, is even able to process the information- the market has already shot up and the HFT firm is earning a profit.

3. Automated trades: This is where HFT really has a huge edge over retail investors and traders. By constantly scanning the markets for discrepancies in pricing, HFT can deploy arbitrage, market making, and sorts completely automated strategies. It might sound like this is unfair, and one can make a strong argument for that case; however, from a price discovery point of view, nothing beats HFT in ensuring that the price of a stock, future, option, or any financial product is priced efficiently and as quickly as possible. Think about it this way: would you rather buy shares of Reliance shares at Rs. 1001 when it should be priced at Rs. 1000? HFT firms would go in and immediately sell Reliance at 1001 and buy it back at 1000; this, in turn, helps investors who are looking to genuinely purchase Reliance shares as a buy and hold strategy for the long run.

HFT in India: Understanding the Differences

Many try to group HFT with algorithmic trading; others try to group it with Flash Trading. Neither is completely accurate.

HFT falls within algorithmic trading, and Flash Trading falls within HFT. There are all sorts of algorithmic trading strategies being employed in India, and HFT certainly does not comprise a lot of it.

1. Algorthmic trading is actually done mostly by FII’s or fund managers looking to purchase a large quantity of a specific asset. They will inform their broker that they are looking to execute X number of shares at a price of Y or below; in return, the trader working at the broker’s desk will use DMA (Direct Market Access) to setup an algorithm using the fund manager’s preset rules (for example, to only purchase trades in slices of 1000 shares at a time). In other words, speed is usually not the requirement. The fund manager wants to ensure that his trades get placed within a specified period of time for his investors. Many times, he does not care whether the firm employs automated or HFT technology.
2. Automated trading, which falls under algorithmic trading, is typically used by hedge funds of proprietary trading funds. They look for patterns in price, quantity, and other market information to generate automated, algorithmic strategies. even for these guys, ultra fast speed is not necessarily a requirement.
3. HFT falls under automated trading, and as written earlier, is dependent on a fast price feed. Speed is the name of the game for HFT. Not only are the strategies almost always automated, but every second, millisecond, miscosecond and sometmes, nanosecond matters. HFT firms often compete with each other to see who can get their order to the exchange the quickest.
4. Flash Trading: Finally, we get to the big elephant in the room. Flash trading was prevalent in the West among HFT firms. To get a good understand of how it works, reading “Flash Boys” gives a good glimpse on how it worked. In a nutshell, Flash Trading allowed some firms to get an unfair advantage over other firms by being able to get market information fractions of a microsecond/nanosecond faster than other and reacting to the information. The result was that the US markets were not an open playing field. Fortunately for us, Flash Trading has never been an issue in India because SEBI never allowed such types of unfair practices to be granted permission.

So, in conclusion. If you ever hear of people complaining about HFT and grouping it with “Flash Orders”, you can immediately inform them that while HFT is prevalent, flash trading is not allowed in India. And seeing how the US and European regulatory bodies are clamping down on Flash Trading in a massive way, it is safe to assume that Flash Trading won’t be a problem in India anytime in the near future.

And if he’s still not convinced, ask him to read “Flash Boys”. That should do the trick.

About the Author: Raghu Kumar is a Promoter of RKSV, the fastest growing low-cost brokerage firm in India. RKSV’s clients process close to 4500 Cr. of turnover daily Pan-India. RKSV offers free trades and also allows investors and traders to do trades for Rs. 20 per order executed, also also offers unlimited trading prcing plans for active traders. Learn more by visiting www.rksv.in

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