What is High Frequency Trading and how does it work?

High Frequency Trading, or HFT is becoming a hot topic these days.You may have heard about this in movies or in discussions on TV.

High Frequency Trading is defined as measuring the holding of a particular security in a matter of milliseconds. It may last up to a few seconds or hours. HFT is achieved by analyzing trends in the tick data in order to make buy or sell decisions.

High Frequency Trading employs complex algorithms that crunch the incoming market data. This is done in an effort to identify any shifts in the market and send out lots of orders into the markets at the bid/ask price that is presented in an effort to anticipate the market movements and thus beating the trends.

One can draw a similarity between high frequency trading used by institutional clients and forex scalping employed by retail and individual traders.

The concept remains the same, which is to rely on speed of execution in order to act quickly on the market data, something which only non-dealing desk Forex brokers can provide in today’s retail forex marketplace.

Characteristics of high frequency trading

High Frequency trading has some basic characteristic features that are defined below.

  • Limited amount of capital that can be used
  • There exists a high ratio of manual/labour intensive costs to the trading profits
  • Fund raising on immediate empirical performance instead of focusing on theoretical expectations relevant to a certain type of investment style
  • Institutional firms use HFT which is highly quantitative in nature
  • Results are highly sensitive to the processing speed
  • Makes use of algorithms to analyze market data and create buy/sell opportunities

HFT is usually not suitable for the derivatives markets, or the OTC.

Technical analysis makes up for a key element to the success in High Frequency Trading. Most successful traders make use of their own custom combinations of Technical analysis in order to gain an edge in the markets.

Where is high frequency trading used?

The key with HFT is to make profits, quantified in cents but based on the quick market fluctuations.

HFT is primarily based up on the short term movements where traders look for any short term trends so as to profit from such discrepancies before the markets correct themselves again.

High Frequency trading, which was previously used by big institutions such as Goldman Sachs came into the spotlight when news broker about a former employee of Goldman Sachs who was accused of stealing the trading secrets of Goldman Sachs’ high frequency system.

Most big and independent firms make use of HFT and they make up almost 60% of the trading volume.

High frequency trading is a by-product of using algorithmic trading strategies.

Controversies surrounding HFT

Regulators, especially in the US and Europe decided to clampdown on High Frequency Trading. It was because HFT became the primary suspect in the sudden Flash Crash in May 2010. On this day, the Dow plunged 700 points only to recover a while later.

Various studies conducted initially did not give a real answer. Investigations later found that the flash crash was a result of spoofing.

High Frequency Trading in the retail Fx industry gave rise to many forex brokers offering low latency systems. Direct Market Access (DMA) is one such example. Brokers also employ the FIX-Protocol. This is the most reliable way to send financial transactional messages in the market.

HFT techniques are not viable for an independent trader. Traders mix high frequency trading with automated trading. This is because these two provide an almost similar environment. Speed of execution. But you cannot compare these two at all. This is similar to comparing a home built car with a Ferarri.

A more refined retail version of HFT is what we know as scalping. It is widely in use by retail and independent forex traders. Still, it is no where close to HFT.

The success with scalping directly relies on the market data and the speed of execution. Therefore, ECN forex brokers have started to gain more prominence in the markets today.