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High frequency trading (HFT) have generated a lot of debate in global media on its usefulness for market participants. Before looking at how an investor should capitalise from these trades we shall take up the question of advantages and disadvantages of HFTs in the Indian scenario and how retail investors can trade in such a competing environment.
The biggest advantage that an HFT brings to the market is liquidity. Exchanges worldwide incentivise HFTs. HFT increases volume in their exchange which in turn attracts bigger investors to the exchange. Exchanges like HFT as they create huge volumes and thus reduce the impact cost. Of course, for stock exchanges higher volumes means higher turnover and higher revenues. Exchanges incentivise the HFTs by giving a discount on some of their charges. For a retail investor higher liquidity means easier entry and exit at a much lower cost to buy and sell.
Studies in the US have found out that on an average an HFT earns 0.2 cents per share traded. If statutory expenses are removed the profit left on the table is 0.1 cent per share. Very few traders or funds would be interested in chasing this type of profit margin. The reason an HFT creates volume is clear from the fact the even to earn a profit of $10,000 they would have to trade 10 million shares in a day.
HFTs bring in the latest technology with a very strong understanding of microstructures on how the market operates and how order flows and is prioritised in the system. Indian markets saw a dramatic change after electronic order routing system was introduced in the country. HFTs have corrected the mispricing in the system between two stock exchanges.
Let me begin with the perceived problem - HFTs cause huge fluctuations in the market. But nothing can be further from the truth. Firstly, because of the liquidity that is present in the system it is not possible to create such big moves unless a majority of HFTs are acting in tandem. What happens is a series of stop losses gets triggered in case of a sharp move which causes a cascading effect. These moves are generally so rapid that even HFTs orders are not triggered. These stop losses can be those of HFTs as well as other traders. So let us move to the real issue.
The biggest disadvantage is that a retail investor cannot generally be a part of the HFT setup. There are few HFT funds that have schemes open for public participation in them. The other big disadvantage is the loss in job opportunity for arbitragers and jobbers whose role has been taken away by the HFTs.
HFTs are one of the main reasons for the poor performance of arbitrage funds. The basic goal of HFTs and arbitrage fund is to take advantage of mispricing in the market. Since HFTs are faster, they take away a major chunk of the profit from the jaws of the arbitrage funds.
Trading along with HFT
There are some algorithms which disclose big pending buying or selling orders giving a false feeling that an institution is about to enter the stock. Investors, especially the intra-day traders need to be aware of such tactics of HFTs which is done either with intention of luring in investors or to slow the system down to have an upper hand over competing HFTs.
A number of algorithms are trend following ones that is they trade in the direction of the trend. HFTs add more power to the trend which an investors can take advantage of. It is very difficult to make money by standing on the wrong side of an HFT. But one can trade on what is left behind by the HFTs. One such type of trading strategies that is generally used is creating a false temporary momentum in a stock. This momentum attracts other HFTs and retail investors. But the HFT that started the momentum in the first place knows that there is little fundamental in the move and hence exits with a profit when others enter. A retail investor can trade fading the move, or enter when the HFTs have exits and volume have dried but there is still some space left for the price to go back to its normal level.
HFTs have the advantage of using technology to move from one stock to another, but the retail trader can select his set of stocks and study the movements of these stocks and how the HFTs enter and exit them. Since HFTs are program traders, they follow a system of entry and exit. They leave their footprints after each trade. A study of these trades will help in understanding their style. HFTs are predictable and trading along with them is the only way to keep up with them.