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What is High-Frequency Trading (HFT)?

The world of retail investing is huge, and there is a lot to learn at every corner from stocks to Forex and commodities. But what lies beyond this realm? What do retail traders need to know about institutional trading and how do large firms operate? More importantly, how do the actions of professionals affect the markets in terms of liquidity and asset pricing?

In this article, we will explore what HFT is, the kind of traders that use this method, and its advantages and disadvantages. If you are interested in learning more about how financial markets work beyond retail investing, read on.

What is High-Frequency Trading (HFT)?

High-Frequency Trading, abbreviated to HFT, is a method where traders use powerful computer programmes to place and execute many orders. These transactions take place in a fraction of a second, and therefore no traders participate in HFT manually – as it is simply not possible.

Traders will use complex algorithms to analyse markets, and they will set parameters for the automatic execution of their trades. Due to the speed at which traders trade, the faster their server speed, the higher the chance of success they will have.

How to determine if a trader is ‘high frequency’

There is no set of criteria that qualify traders as high frequency. However, you can use these metrics to gauge if someone is participating in HFT.

  • Turnover rate

In trading, the turnover rate is the percentage of a trader’s portfolio that experiences replacement.

  • Order-to-trade ratio

The order-to-trade ratio is the ratio of the number of order entries (orders placed) to the number of orders filled (orders executed).

  • Use of high-speed programmes

Finally, if a trader fulfils one or more of the above features and uses high-speed and sophisticated trading programmes to trade, they may be participating in HFT. This is because the average CPU simply cannot handle the complex algorithms traders use.

Who participates in HFT?

There is a great number of individual traders who participate in HFT, despite the need to use sophisticated software for it. Usually, these are advanced and sometimes even professional traders who have sufficient experience working with algorithms and creating their own. They attempt to make a small profit with each trade, and they trade up to hundreds of times a day, building up their profits.

On the flip side of the coin are high-frequency firms. These firms take on the role of market makers, and they create bid-ask spreads for products such as Forex. They also create low-priced, high-volume stocks each day. They earn a profit from networks and exchanges for providing this liquidity.

Many professional traders also employ institutional investors that participate in HFT. These traders participate in ‘proprietary trading’ and use the firm’s funds instead of those of their clients. The firms profit from using different forms of arbitrage, including index, volatility, statistical, and more. The edge that investors at HFT firms have is the advanced technology they have access to, giving them ultra-fast order execution speeds.

Techniques employed in HFT

The most common way these institutional investors make money is by trading on both the buy and sell sides with algorithms. This means the traders place long and short orders within certain parameters, and they derive a profit from the difference between the current market price and the positions they take.

As mentioned, institutional investors may also profit from statistical arbitrage. This is when they look for price discrepancies between different markets of certain securities. When they find inconsistencies across exchanges, they perform HFT and capitalise on the discrepancies.

Advantages of HFT

There are advantages for participants of HFT. They include:

  • Ability to profit from small market movements

Whether a trader is trading currencies or other types of securities, HFT allows them to make sizeable profits even when the market is not moving by a lot. A trader can compound small gains and build up profits that way.

  • Ability to participate in different markets

Traders can trade various assets and markets when they participate in HFT. This enables them to find new opportunities and diversify their portfolio to reduce the overall risk of trading.

  • No overnight charges

As traders hold positions for a very short time and never overnight, they will not incur certain charges such as overnight fees. They may also be able to negate high transaction costs by opting for a service or broker that offers a sliding scale commission.

There are also advantages that HFT brings to other traders and to the market. They include:

  • Increased liquidity in the market

Due to the high transaction volume of HFT traders, the markets they trade remain very liquid. This helps other traders execute their trades faster when they can find suitable buyers and sellers quickly.

  • Lower bid-ask spreads

Naturally, the enhanced liquidity of the market leads to lower bid-ask spreads. This lowers the overall cost of transactions for all traders.

Drawbacks of HFT

Nevertheless, many have labelled HFT a controversial activity that brings some unique risks and drawbacks. They include:

  • Increased market volatility

HFT can create increased market volatility because of the high volumes traded in small timeframes. It may even lead to market crashes, depending on the circumstance. This can create a huge risk to other traders.

  • High risk-reward ratio

Another risk associated with HFT is the high risk-reward ratio it naturally offers traders. Traders execute hundreds of trades in a short timeframe, which is much riskier than traders who abide by a long-term strategy. This is because it is much harder to try and time market performance than it is to ride through market fluctuations over time. Nevertheless, it is this high level of risk that makes HFT an attractive method for many investors who enjoy the thrill of trading.

  • Controversy on ethics

A final issue that people may have with HFT is that of ethics. Some professional traders have expressed that HFT gives large firms and professional traders an unfair advantage because they have access to the most advanced and sophisticated tools to trade. These professionals have also stated that firms tend to profit at the expense of smaller, retail traders.

How to get started with HFT

If you are a retail investor, you should ensure that you have significant market experience before you attempt to participate in HFT. This is because much of the process requires using computer algorithms to trade, so you will need a definite familiarity with complicated systems and algorithms to set up your own. You will also need to acquire significant capital and sophisticated hardware and software to aid you.

If you are nevertheless interested in HFT, you may consider becoming an institutional investor and working at an HFT firm. However, you will need professional qualifications to build a career out of trading, and not everyone can casually participate.

The bottom line

HFT is certainly not for everyone, and there are a few key financial firms that dominate this arena. If you are looking to join one, you will need to meet certain criteria, such as specific educational qualifications. HFT is also a high-risk activity that requires sophisticated tools and high-speed connectivity beyond what is possible for regular CPUs. Therefore, retail traders are much better off focusing on traditional investing. Nevertheless, knowing more about how the financials works – including the parts that do not affect you directly – can help you become a more well-rounded trader.

If you are interested in reading more about how to trade and different types of online trading, make sure to check out “What is CFD Trading?“. This article explores how contracts for differences can be traded and provides some useful tips on what to do as a beginner! It also provides a brief introduction to different types of CFD trading such as Intraday, daily, and weekly trading.

If you are interested in Bitcoin Margin Trading, then also take a look at this informative article that dives into the different types of platforms that are used by crypto traders and outlines what every crypto trader should know!

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