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High frequency trading is a quantitative trading tool that uses computer algorithms to analyse market data, deploy appropriate trading strategies, minimise cost of trading and execute trades.
Algorithms are used to interpret market signals and patterns and trades are executed and reversed within a fraction of a second, multiple times during the trading session to generate profits. Volumes are huge and the spreads fine. Hence, the HFT algorithms target the most liquid segments of the market.
HFT is generally used by proprietary traders and trading firms and the most commonly used strategies are market making, arbitrage and directional trading.
Speed of execution is top priority and HFT makes use of direct electronic access to markets and co-location of servers to reduce time taken to execute transactions.
Japanese Yen crash
The Japanese yen fell 300 pips from ¥79.50 to ¥76.50 in 25 minutes early morning of March 17, 2011, between 5:55 AM and 6:20 AM, usually a lean period for trading. It recovered to ¥78.23 in the next 30 minutes. The move was linked to the compulsory stop loss trades for retail forex margin traders executed by retail aggregators.
The timing coincided with the time of the day when retail aggregators shut down their systems to calculate daily outstanding client open positions and client margins. As a result clients could not post additional margins and this triggered a free fall. Banks refused to make a market (provide liquidity) and those who did, widened their spreads (difference between buying and selling rate).
Dow Jones Flash Crash
In the afternoon of May 6 2010, major equity indices on the Dow Jones suddenly fell 5- 6 per cent in minutes and recovered immediately. Indices had fallen four per cent the previous day.
Almost 8,000 stocks and exchange traded funds declined 5-15 per cent and recovered most of their losses. Over 20,000 trades across more than 300 scrips were executed at prices that were more than 60 per cent away from their values moments before. The day ended three per cent below the previous close. A joint report filed by the securities and the commodities market regulators in the US observed that liquidity could rapidly erode and result in disorderly markets due to automated execution of algorithm trading strategies under stressed market conditions.
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