We talked earlier about algorithmic trading. In this material we want to talk about HFT or high-frequency trading, which is one of the kinds of algorithmic trading. Let’s get acquainted with the principle of this type of trade and examine several strategies.
Definition
HFT or high frequency trading is a type of algorithmic trading. Its main features are:
- High transaction speed.
- Rapid capital turnover.
- Short terms of ownership of the asset.
As with algorithmic trading, high-frequency software and hardware will be needed. It can be said that high-frequency trading will be more expensive, because transactions have to be made in the shortest time, therefore software will not save here.
HFT traders are often credited with trading in Dark Pool, an alternative trading system whose essence is this: Pool members can post orders, but they will not be available to the rest of its members until the transaction is completed.
Yes, the lots traded by HFT traders are very small in relation to other stock exchanges. This does not mean, however, that there is no substantial capital behind them. As it has already been said, HFT trading is a very expensive pleasure, therefore only wealthy participants come to it.
Now imagine how a price can change when a HFT trader with a huge deposit trades? For information, HFT trading can open several hundred thousand deals per day and several hundred or thousands per second. You can see more clearly the principle of high-frequency trading in this video. it shows how many transactions happen in one second.
Back to Dark pool. If any trader wants to sell a large amount of an asset on the stock exchange, it will face:
- With a decrease in the value of the asset, after the sale of the first few lots.
- The activation of speculators who want to make money on market volatility.
Moreover, it is much easier to find a buyer for the entire asset on over-the-counter platforms. Therefore, HFT traders love trading in Dark pool – there are fewer problems.
What will be required for HFT trading?
This type of automated trade is quite expensive, so it is not suitable for any market participant. Let’s explore how to join the ranks of HFT traders in more detail:
- The simplest option is to find a broker who specializes in high-frequency trading. In that case, it would not be necessary to deal with complex software or to purchase expensive equipment. However, you will have to pay for the broker’s services, but the price will be clearly lower than if you try to engage in HFT trading on your own.
- The second option is recommended only for those who have already experienced high frequency trading. It is possible to purchase the necessary software and equipment on your own, as well as to purchase the coloring service. Coloration is a service provided by the provider. It is that the client’s equipment is located on the territory of the provider, usually – in the datacenter. This approach ensures that quotations are updated as quickly as possible, and this is a crucial factor in HFT trading.
It is worth noting the difficulties faced by anyone who intends to engage in high-frequency trading on their own:
- When you buy a ready-to-use software, it doesn’t have the right algorithms or strategies. This will have to be decided by themselves or by using the services of more qualified traders, which implies additional costs.
- Algorithms and strategies are configured, now you have to configure the program itself to work. Here is the same story as in the first paragraph.
- If you decide to use the services of a broker, then all of the above settings will be included in the price. However, you will need to pay for the colocation separately, because brokers do not add this service to the mandatory ones.
Anyone who wants to devote himself to high-frequency trading should understand that it will require a lot of investment. Besides, the deposit must be impressive.
Strategies
Now let’s talk about the most famous high-frequency strategies:
- Execution. Involves the execution of large orders by institutional investors that have little or no impact on the price of an asset. If a large order is placed in an exchange cup, it will affect 100% of the value of the asset. Therefore, one large warrant is broken down into many small ones, and then they are executed. The whole process takes place in a short time, at the expense of the speed of execution, but the price is not affected.
- Order Flow Prediction. Depending on the market situation, HFT traders try to forecast large warrants to open positions early and make a profit.
- HFT-arbitration. Regular arbitrage trading, that is, making a profit from the difference in the price of an asset on two platforms, only in an accelerated form.
- HFT market-making. They imply the establishment of a quote and its constant updating.
Flash Crash
Flash Crash is an instant market crash followed by an equally rapid rollback to previous values. HFT traders are often accused of Flash Crash, and the best-known incident occurred on May 6, 2010.
In short, in 2010, a guy crashed the U.S. stock market. This guy’s name is Navinder Singh Sarao. From the age of three, he lived with his family in London. The family is poor, the father is suffering from diabetes mellitus, and Sarao has Asperger’s syndrome – retardation in social development. Most likely, the disease contributed to the development of the mathematical and financial sides in the guy. Sarao entered the local university at the Faculty of Economics, after which he began working in the trading company Futex. At the age of 30, the guy was earning about €250,000. In 2009, Navinder left the company and began independent trading. He managed to earn about $50 million without leaving the room.
On May 6, 2010 the «black Thursday» occurred: in five minutes the Dow Jones index scored 600 points. If we’re talking about the crypto market, it wouldn’t count as a meltdown, but in traditional markets, it’s a little different. The overall fall in the index was about 8%. Sarao managed to do this as follows: the method «spoofing» – imitation of the application was used. On this unfortunate day, Navinder put out a huge pseudo-bid to sell, which served as a catalyst for temporary panic. He was not the only one to use different software, so the programs of other market participants began to exhibit smaller lots, at the same or an even lower price. As a result, the index collapsed very quickly, and Navinder was able to purchase the asset at an underprice.
The interesting thing is, they didn’t find the guy until 2015 and extradited him to the United States. He was accused of manipulating the financial markets; in five years, Sarao was able to earn more than $12 million by spoofing. By the way, this method is now prohibited by the Dodd-Frank Act, which makes its use a criminal offence. He was initially threatened with 380 years in prison, then reduced to 30. As a result, he avoided prison altogether. In return, Sarao helped the authorities investigate financial crimes on the stock market. However, he was banned from trading for life.
Conclusion
High frequency trading has gained popularity in financial markets, as indicated by statistics: in the results of 2020, 70% of trading in stock markets are in HFT-trading. So if you’re really interested in high-frequency trading, this is a great opportunity to make a living. But you should remember that it is expensive.