In the last twenty years or so, the stock markets around the world, and particularly in the US, gave gone through some significant evolutionary changes. Over the last two years, it could be argued that the changes have become revolutionary.
The most significant change has been the growth of algorithmic trading and high frequency trading (HFT). Since the markets started to go electronic back in the 80’s, the use of computerized trading systems has grown exponentially and it’s in the last two years that the high frequency traders have taken the lion’s share of the volume. Roughly seventy percent of all volume traded on US stock markets can now be attributed to HFT. In other parts of the world it is less (around 30% in Europe and less than 10% in Asia) but those figures are growing rapidly.
So how does HFT actually work? What do these lightning-fast traders do and how are they able to consistently make profits? It basically comes down to three main factors. First, they develop computer models that can identify trading opportunities allowing them to lock in small profits. Second, they put in place very high-speed communications links to the various exchanges and other execution venues where they do business. Third, they run their models and algorithms at extremely high speed, locking in those small profits again and again and again. Let’s face it, on Wall Street, one trade that makes a couple of hundred dollars is nothing to write home about, but if you are doing that few thousand times a day, day in and day out, it means you are generating significant profits on a consistent, predictable basis, which is every investor’s dream!
However, high frequency trading has come in for a lot of criticism over recent months and the regulators (the SEC and the CFTC in particular) are now looking at whether the existing market infrastructure can cope with the growth of this kind of activity and if not, what kind of changes will need to be introduced to ensure a fair market for all.