146
ELI5: Why is high frequency trading allowed?
(lemmy.ca)
you are viewing a single comment's thread
view the rest of the comments
view the rest of the comments
this post was submitted on 31 Aug 2024
146 points (100.0% liked)
Explain Like I'm Five
14205 readers
2 users here now
Simplifying Complexity, One Answer at a Time!
Rules
- Be respectful and inclusive.
- No harassment, hate speech, or trolling.
- Engage in constructive discussions.
- Share relevant content.
- Follow guidelines and moderators' instructions.
- Use appropriate language and tone.
- Report violations.
- Foster a continuous learning environment.
founded 1 year ago
MODERATORS
If you strip things back, the most fundamental point of a market is to bring buyers and sellers together and to enable price discovery.
The price of a financial instrument you see on a stock exchange or similar is simply the last traded price between a buyer and a seller. If you want to buy or sell something, then the price you get depends on who wants to sell/buy on the other side and what price they have put an order in for.
The more trades going on in the market, the more likely it is that you will be able to buy at a price close to what you see as the last price in the market.
If you only allow trading every hour, then you lose some of that price discovery.
Additionally, as already mentioned, trades would likely still happen, but away from the designated marketplace. If I want to sell something, then I may just ask who else has the thing I want to sell and try to negotiate a price directly with them.
That way, fewer trades happen in the marketplace and more trades happen in private away from there.
That sort of limited trading does happen for some very niche products that don’t have a lot of potential buyers and sellers. For common financial instruments, have a lot of participants wanting to trade, having a centralised marketplace helps avoid the issues that would come otherwise.
Now, you can argue that in practice it doesn’t work as well as the theory, and I would agree there. If you are a HFT, then you can make money by getting in milli or microseconds ahead of others.
For a lot of market participants, that doesn’t really matter though. The big banks typically don’t do that sort of trading. They are buying and selling on behalf of their clients, both individuals and companies that want access to the market. The bank makes their money by charging a margin to their client (similar to how it works for pretty much any retailer), and the fact that the HFTs are making all these trades helps them with price discovery and liquidity (ensuring there is someone to buy what they want to sell, or sell what they want to buy)
The way you describe it, it seems like pieces of corporations ownership are not different from nft or shiny rocks...
I mean, why does anything have value?
In the strict financial sense, something is only worth what somone else is willing to pay for it. That's the whole premise of financial trading. Getting a bit beyond ELI5 now, but most exchanges use something called a Central Limit Order Book (CLOB) to let the participants in the market see who wants to buy and sell what and for how much, and also to match those buyers and sellers. This is a good intro: https://optiver.com/explainers/orders-and-the-order-book/
In terms of shares in companies, then they do have some fundamental value according to the market. If you buy a share in the company, you get a share of the profits (paid as dividends), which gives those shares some value. Obviously, there's a lot of speculation too as people are involved, so emotions and wild predictions can come into play!
Financial instruments that get traded aren't limited to shares in companies though. There are all kind of other financial instruments that get traded every day, some are pretty basic like buying and selling different currencies. Others involve all kinds of crazy financial engineering , like the sort that caused the crash in 2008!
Most have some fundamental value based on their attributes, so it's a little different to the likes of an NFT. The big issues come if the values that the market has agreed upon don't match reality, which is what happened in 2008.
I know the theory. In essense, the stock market (I was told) should predict the performance, strenth or beneficiality of a corp, but I guess that's wrong.
Also, by this measure a tree in the forest is worth nothing, but a cut and tree, and the land that it leaves behind are worth a lot. Teachers, nurses and "non skilled" workers are worth almost nothing, but market brokers are worth a lot.
TIL. The Wikipedia article.