What are High Frequency Trading Strategies? - Profit and Risks
Have you ever heard of high frequency trading? This is a type of automated trading, designed to go fast, that uses complex algorithms and is generally not accessible to a retail trader. In this article, we will explain what this type of trading entails, its advantages and disadvantages and much more!
What Is High Frequency Trading?
High frequency trading is an algorithmic trading method in which a large number of orders for financial assets are issued in a matter of milliseconds. The orders are sent to the market where some will be executed and others not.
The incredible speed at which orders reach the market is only achieved by very powerful computers that use complex algorithms. It requires very advanced technology, algorithm programmers and, most importantly, a lot of money! This is why this type of trading is typically used by hedge funds and specialist investment funds.
Let’s take a look at the general characteristics of high frequency trading:
- It requires very sophisticated technology, which is not within reach of a retail investor
- The computers are physically located near the trading centres so that the orders arrive to the market as soon as possible
- Orders never remain open past the end of the trading session
- The profits from each trade are minimal, therefore, thousands of orders are opened for greater potential gains
A Little History
High frequency trading started in 1999 after the US regulator, the Securities and Exchange Commission (SEC), authorised electronic transactions. However, at the time the speed at which orders were launched into the market were not as fast as today, taking seconds to reach the market. A decade later, orders were arriving in the market in milliseconds.
During the first decade of the new millennium, this type of trading grew enormously in popularity. A report by Deutsche Bank Research states that in Europe, the percentage of high frequency trading compared to total transactions rose from zero in 2005 to around 40% in 2010. In the United States, high frequency transactions grew from 20% in 2005 to 60% in 2009.
Following the 2008 financial crisis, high frequency transactions began to decline for two reasons. Firstly, the cost of the necessary infrastructure was increasing while profits were decreasing. Furthermore, alternative trading platforms emerged and regulation surrounding high frequency trading was tightened.
2010 Flash Crash
On the 6 May 2010, a phenomenon called the Flash Crash occurred affecting the Dow Jones Index. The US index sank by 9%, around 1,000 points, in just five minutes and then recovered to return to its previous level. This crash was triggered by a computer program and, therefore, at first, all eyes were directed towards high frequency trading.
It was eventually discovered that a London based trader was behind the crash. Navinder Singh had created a computer program that threw false orders into the market to trick the high frequency robots. This is known as “spoofing”. He would then quickly place orders to make a quick profit. The investigation took five years to find the culprit, and Sigh was finally arrested in April 2015.
Since the Flash Crash incident of May 2010 and following the outbreak of the financial crisis in 2008, mistrust of high frequency trading spread and has subsequently led to increased regulation.
In 2014, a book was released which fueled suspicions. The book was written by former broker and financial journalist Michael Lewis and was titled “Flash Boys: A Wall Street Revolt”. The book stated that these high frequency machines manipulated the market so that the big banks always won. It ranked first among best selling books for weeks, further sowing discontent among the public against banks, which led to the birth of movements such as Occupy Wall Street.
In short, high frequency trading has many opponents, but it also has proponents. Critics believe that high frequency traders first fool, and then take advantage of the market. They also complain of the short amount of time trades are left open.
On the other hand, however, many argue that these orders provide the market with not only more liquidity, but also counterparties for both sides.
In the following sections, we will look in more detail at the advantages and disadvantages of a high frequency trading strategy.
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- Increases liquidity within the market
- As a result of the above, and the increase in trading volume, high frequency trading helps reduce spreads
- No intermediaries are needed between trader and market, orders go there directly
- Reduces volatility during normal times
- Not accessible to retail traders, only to large banks, investment funds and hedge funds who benefit from the latest technological advances and abundant capital
- May cause damage to other investors in the market or lead to mispricing
- The high speed at which trades are sent to the market gives an unfair advantage over any human traders
- Can magnify volatility during volatile times or when something goes wrong with the software
- Transactions are based largely on technical analysis with the fundamentals somewhat overlooked
What Are the Risks of High Frequency Trading?
High frequency trading also involves certain risks:
- Communication failures within the networks or computers themselves
- Can be used for manipulation. For example, in 2014 the SEC accused a high frequency trading company of using an algorithm to manipulate the closing prices of shares on the NASDAQ in 2009. The firm had to pay a fine.
- If left unchecked, mistrust of of the market will develop from other investors
In the United States, the main regulation governing high frequency trading was passed in the wake of the financial crisis of 2008: the Dodd-Frank Act of 2010. One of its chapters is entirely dedicated to high frequency trading and, in particular, prohibits the spoofing we have discussed above. In addition, the SEC and the Department of Justice stepped up investigations and committed resources against fraud and market manipulation.
In Europe, the European Securities and Markets Authority (ESMA) has established certain obligations for trading venues in MiFID II - MiFIR.
For example, a trading venue “must have at least systems (including transaction and order alert systems) with sufficient capacity to process orders and transactions generated by high frequency trading, low latency trading systems so that it is possible to monitor and…detect any activity that may involve market abuse (and in particular market manipulation, including the monitoring of other markets as soon as the venue has access to them), and to track retrospectively both transactions undertaken by members, participants and users and orders entered and cancelled that may involve market manipulation".
Furthermore, "trading platforms should conduct regular reviews and internal audits of the procedures and mechanisms in place to prevent and detect practices that may constitute market abuse". Also all investors, with few specific exemptions, must be authorised by the financial authorities under MiFID II.
As noted above, high frequency trading is not available to all traders. However, trading using Contracts for Difference (CFDs) is available to any retail trader! CFDs are derivative products that allow speculation on the upward or downward movement of asset prices.
If you want to start trading CFDs on shares, currencies, commodities, and other asset classes, you can either open a free demo account or open a live trading account and start trading now. Click the banner below to open an account today!
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.