Robots, Returns & Reality: What Most People Get Wrong About HFTs in India

Coming on the heels of the Jane Street case, common reactions to news about High Frequency traders (HFTs) fall into one of three buckets:

• ‘Algo’ orders comprise anywhere between 50 to 80% of traded volumes on Indian exchanges,  robots are taking over and are responsible for my trading profit coming down over the years.
• Did you hear about the latest packages offered by HFTs? More than 2 cr for someone’s first job! Should’ve studied engineering.
• HFT firms are making crazy money! Why don’t I also start one? After all, it’s just trading but quicker, right.

In this article, We'll try to dispel some of the myths surrounding the high frequency trading world

All algo orders are basically HFTs and they drive up prices

SEBI, the market regulator, classifies any order which is triggered without human intervention as an algo order. These can be a simple algo such as buy a stock at 10.00 am and sell at 10.05 am each day. Advanced execution methods such as slicing (dividing a large order into smaller chunks and sending each to the exchange at pre determined time or traded volume intervals) and multi leg orders (placing orders for more than one instrument at a time, usually as part of an option trading strategy) are also classified as algo orders

While the majority of algo orders may well be HFT orders, not all are. Moreover, SEBI requires all algos to provide liquidity to the market by placing only limit orders. Algos are banned from placing market orders that take away liquidity from the market. While the jury is still out on whether algos are harmful for the market, there’s no doubt in india that they add liquidity to it due to SEBI’s regulations.  

HFTs can make unlimited profits

Algo strategies in general have a certain capacity, due to impact costs, which are the reduction in profit due to placing the order. Put simply, buying too much of a stock causes the price to go up, which increases your entry price. Impact costs along with trading costs that every trader pays, can quickly add up, especially when HFTs trade multiple times each second. While HFT firms can make steady, consistent returns going up to hundreds of crores of profits for some of the larger shops, they can’t get the benefit of compounding beyond that point, the way a long term investor would. It’s a great starting point if you can make it work though!

HFTs make profits regardless of market direction

Most HFTs use market making algorithms, which seek to profit from the difference between the best bid (the highest price the market is willing to buy from you at) and the best ask (the lowest price the market is willing to sell to you at). These algorithms place both buy and sell order to take advantage of this spread. Naturally, they are hoping that both the buy and the sell orders are hit, otherwise you end up with inventory, either long or short. So the ideal market scenario for this is a range bound one, where the buy and the sell orders are both hit. Conversely, a trending market, where prices move only in one direction, either up or down are not good. So most market marking algorithms incorporate a short term price prediction, and when the market is too directional, they stop placing orders and exit the market until it stops trending.

HFT profits are risk free

Market making is far from straightforward, and when you’re dealing with such fast moving algorithms, mistakes can be very costly. Case in point is the Knight Capital Group, which used to be a major HFT in the US. In 2012, due to human error resulting in an improper piece of code, they lost around $440 million within hours, which directly contributed to their subsequent sale to another HFT some time later. Years of hard work to build up a world class trading firm washed away in minutes.

Becoming an HFT is easy

Beyond the obvious point that nothing in life is easy, there are a number of challenges that HFTs face.

More than half of algo orders are placed via servers collocated in the exchanges. Only trading members of the exchange are allowed to do this. Becoming a member or a broker, needless to say is a time consuming process which can take more than a year. Once you get your membership, there are a huge number of compliances which need to be carried out daily.

A major challenge is that it is difficult to create an enduring moat in an HFT firm, as the strategies and know how are linked to people’s knowledge, and when such key people leave either to rival trading firms or to start their own shops, chances are some of the profit may leave with them too. 

Another challenge is that strategies have alpha decay, which is a phenomenon where as more and more traders become aware of a trend in the market on which a strategy is based, the returns from the strategy reduce.

Conclusion

While there is no doubt that the HFT business can be extremely lucrative, it is also a zero sum game where the winners take all, therefore not easy to make money for all players, unlike regular trading where there is scope for large and small investors alike to generate returns. Therefore, becoming an HFT is not for everyone! As has often been said, trading in general is the hardest way to make easy money, and just like any business, most traders actually don’t.

Disclaimer

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