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Breaking it Down: An Overview of High-Frequency Trading

Advanced Trading takes an in-depth look at high-frequency trading, from a basic definition of the trading style to the details on who is leveraging it and how much they're trading.

HFT By the Numbers

While defining high-frequency trading is a tough job, estimating the volume and profits of high-frequency traders can be even more complex. Recent TABB Group estimates indicate that 70 percent of U.S. equity trading volume, or 61 percent of share volume, is a result of high-frequency trading. As for profits, the firm's Iati estimates put the potential revenue available for capture in the high-frequency arena at about $8 billion a year.

"That is what is available out there based on our calculations," says Iati, who cautions that it is not necessarily how much firms are raking in via the strategy. "It varies based on how much of that opportunity is actually captured."

But how does TABB Group arrive at these numbers? Iati explains that there is a large amount of information available in the public domain, including information on assets under management (AUM) at hedge funds and retail order flow. The Westborough, Mass.-based advisory firm combines this publicly available information with proprietary data culled from its institutional research studies, such as average daily volume (ADV). Those numbers are then applied to the broader universe of trading stats. "We have our own sample as a proxy and use our sample of AUM and ADV to help model the broader marketplace," Iati says.

Though sophisticated, TABB Group's methodology is not an exact science, and the industry's high-frequency-trading numbers are still up for debate. Woodbine's Samelson pegs high-frequency trading at about 40 percent of overall market volume today, with electronic trading accounting for up to 70 percent of total equity volume. According to Samelson, however, it is extremely difficult to put a dollar amount on this volume. Joseph Mecane, EVP and chief administrative officer for U.S. markets at NYSE Euronext, estimates that at least half of the liquidity in the market is generated by high-frequency trading or automated market making.

Who Is Trading?

Just as it is difficult to define high-frequency trading, it is a challenge to define the high-frequency traders. Telesis Capital's Narang says generally there are two types of high-frequency traders in the market. The first is a liquidity provider or market maker, such as Getco, Citadel and Tradebot.

The second is a more serious buy-side alpha trader. "They are not just out there trying to provide liquidity; they are trying to forecast near-term movements in instruments -- not just stocks," Narang explains. "They are implementing their strategies on a fast infrastructure to move in and out of positions quickly."

High-Frequency Trading Volume for U.S. Equities
Narang also points out that while the liquidity provider-type of high-frequency trader may have an alpha component in its strategy, the alpha trader-type generally does not have a market-making component in its strategy. "The market maker-type often employs some type of forecasting to help decide what to own or what to avoid," he says.

TABB Group's Iati goes a step further, defining three types of firms that generally are high-frequency traders. First, he says, there are the traditional broker-dealers undertaking high-frequency strategies on their proprietary trading desks, separate from their client businesses. Second, he points to high-frequency hedge funds. Third are proprietary trading firms that are mainly using private money (see related chart for volume breakdown).

"Not all of these [proprietary] shops are the same, though," Iati adds. "There is a separation based on how they trade, and the clearest delineation runs between virtual market making and everything else." The virtual market makers, he explains, are primarily providing liquidity into the market and profiting from rebate trading. The "everything else" category of proprietary shops generally makes its money from arbitrage opportunities.

While it is tough to say with certainty how many high-frequency firms fall into each category, Iati estimates that there are between 10 and 20 broker-dealer proprietary desks and fewer than 20 active high-frequency hedge funds. The hardest category to quantify, he says, are the independent proprietary shops, which he numbers at more than 100 but less than 300.

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