High-frequency forex trading is not a new concept in the financial markets. It is an activity that is carried out by large investment banks, hedge funds, and institutional investors using an automated trading platform. Driven by powerful computers, it processes a significant number of orders in a short time.
Specialists and pit traders have been buying and selling positions at the exchange site, using high-speed telegraphs to communicate with other markets since at least the 1930s.
Since NASDAQ introduced electronic-only trading in 1983, rapid-fire computer-based HFT has progressively grown in popularity. HFT transactions took several seconds to execute around the start of the twenty-first century, but by 2010, this had dropped to milli- and even microseconds.
Until recently, the public had no idea what high-frequency trading was, thanks to a New York Times piece published in July 2009 that first brought the matter to light.
As recently as the early 2000s, high-frequency trading was still a small percentage of equities orders, but this percentage was shortly to expand rapidly. The volume of trade on the New York Stock Exchange (NYSE) increased by 164% between 2005 and 2009, which might be attributed to high-frequency trading.
There were total hedge fund assets under administration of $141 billion in the first quarter of 2009, down approximately 21% from their peak before the worst of the financial crisis. However, the most significant hedge funds are LLCs controlled by a few individuals.
Renaissance Technologies was the first to popularize the high-frequency trading (HFT) technique, which incorporates both quantitative and HFT elements. To minimize volatility and narrow bid-offer spreads for other market players, several high-frequency businesses act as market makers and supply liquidity to the market.
As of September 2, 2013, Italy became the first jurisdiction to charge equity transactions that are executed within fewer than 0.5 seconds a fee of 0.02% expressly aimed against HFT. An estimated 10–40% of equity trading volume and 10–15% of commodity trading volume were generated by HFT in 2016, according to Aldridge and Krawciw in 2017.
HFT's percentage of short-term trading volume may range from 0% to 100% throughout the day. High-frequency trading was estimated to account for 60–73% of all US equities trading activity in the past, although that percentage dropped significantly to around 50% in 2012.
It is common for high-frequency traders to enter and exit short-term bets at large volumes and high speeds to benefit from each one. For HFT enterprises, money is not used, positions are not taken, and portfolios are not held for long periods.
It is a controversial methodology that eliminates all human decision-making from the trading process. The market can rise and fall in a matter of seconds because of the speed at which deals are executed.
This implies that a single poor deal or algorithmic fault might lead to losses of millions of pounds in a matter of seconds. Subsequently, other high-frequency trading firms could get nervous and spread their fear to other markets.
Concerns concerning high-frequency trading have already been highlighted by the Financial Conduct Authority (FCA), including the possibility that it might disadvantage smaller market participants and distort markets.
Having watchdogs who can keep up and catch any misbehavior is also a danger. The Bank of England's case is being investigated by the UK's financial regulator, the Financial Conduct Authority. There might be an inquiry or a fine if the FCA detects market misuse.
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What is High-Frequency Forex Trading?
HFT, or high-frequency trading, is a kind of trading in which enormous numbers of orders are transacted in a fraction of a second using sophisticated computer algorithms. It analyses numerous equity markets and executes orders depending on market structure and circumstances via the use of complicated algorithms.
The type of high-frequency trader who typically has access to the quickest execution rates is more lucrative than the one with the slowest. Additionally, HFT is characterized by a high turnover rate and order to trade ratio in addition to the fast speed of orders.
Some of the most prominent high-frequency trading businesses today include Citadel LLC, Virtu Financial, and several others. When exchanges began to reward corporations for providing market liquidity, high-frequency trading (HFT) took off. Supplemental Liquidity Providers (SLPs) are a group of NYSE liquidity providers that aim to increase competition and liquidity for the exchange's current quotations.
Following the bankruptcy of Lehman Brothers in 2008, there have been several challenges faced with the liquidity of investors, with the NYSE offering either a charge or rebate to business entities in exchange for these prominent institutions providing market liquidity. Subsequently, this creates a lot of money because of the high-volume transactions carried out daily.
How High-Frequency Forex Trading Works
Large institutions may obtain a minor but noticeable advantage via high-frequency trading in exchange for delivering enormous quantities of liquidity to equity markets.
High-frequency trading systems can place millions of orders, lubricating the market and allowing those who use them to make more money on their successful trades and earn better spreads.
In the end, high-frequency trading is a win-win situation for everyone. There is a volumetric benefit for institutions. Trades must be made in large numbers to reap the full advantage of a transaction since the rewards per trade are so little.
Both the spread for delivering liquidity and the lower transaction fees that trading venues provide to make their financial markets more appealing to high-frequency trading firms are direct sources of revenue for other market participants.
Liquidity and spreads are inextricably linked. Low-volume financial markets tend to have higher spreads than high-volume markets; this is because the spread is the difference between the purchase (offer) and sale (bid) prices for an item.
This astonishing volume produces narrow spreads that only give meaningful profit chances if they are traded in massive quantities, such as the foreign exchange market, which sees over $5 trillion of currency exchanged every day.
In financial markets with significant liquidity, such as forex, traders seek to employ leverage to increase the number of trades to take on larger holdings that would otherwise be unprofitable. Small-cap stocks, which tend to be less liquid, can have wider spreads.
To get an edge in the open market, high-frequency trading systems enable traders to execute millions of orders and monitor various marketplaces and exchanges in a matter of seconds.
A fraction of a second is all it takes for systems to identify new patterns in the market, thanks to complicated algorithms. The trading algorithms can identify market movements and put hundreds of stock baskets into the market at beneficial bid-ask spreads for the traders.
Is High-Frequency Forex Trading Worth it?
Yes, high-frequency forex trading is extremely profitable. According to statistics, HFT’s produce positive gross trading gains on 74% of firm days. However, at 68% of firm days, aggressive HFT’s are the least lucrative.
Despite these statistics, traders need to consider several components to determine whether HFT is suited to their trading objectives. The start-up costs involved with high-frequency trading are astronomical, with traders anticipating initial minimum capital of $25,000 per month.
What are the Types of Algorithms in High-Frequency Forex Trading?
Algorithms are employed for a variety of trading purposes. Typically, algorithmic trading may be divided into the following four types.
- Statistical. Profitable trades are predicted by these algorithms based on a statistical analysis of past data.
- Auto-Hedging. Automated risk reduction is the goal of these algorithms.
- Execution Strategies. Algorithms that are designed for a specific purpose are included in this category. Programmers may choose to reduce the influence on the market, speed up the deals, or do anything else they choose to do.
- Direct Market Access (DMA). A high-frequency trader can easily use these algorithms to access numerous trading platforms at a lower cost and a quicker rate.
High-frequency traders can use any of these algorithms to work swiftly through many deals in high-frequency trading. The modern high-frequency trader must note that while all HFT trading is algorithmic, not all types of algorithmic trading will rely on high-frequency strategies.
Some of the most popular high-frequency trading strategies include:
1. Market Making
2. Quote Stuffing
3. Ticker Tape Trading
4. Event Arbitrage
5. Statistical Arbitrage
6. Index Arbitrage
7. News-Based Trading
8. Low-latency trading
9. Order Properties Strategies
1. Market Making: A “market maker” and an “HFT company” might have a lot in common. It is common for HFT businesses to describe their business as “Market making” — the practice of placing a limit order to either sell (or offer) or to purchase (or bid) to profit from the bid-ask spread.
As a result, market makers help to balance out incoming orders. Many retail investors are increasingly making use of direct market access to execute strategies such as market-making, which was formerly reserved for specialized organizations.
Market creation is a major tactic for certain high-frequency trading organizations.
2. Quote Stuffing: As a method of market manipulation utilized by high-frequency traders (HFT), quote stuffing is susceptible to disciplinary punishment. Any High-frequency trader can take advantage of this by rapidly entering and withdrawing huge numbers of orders to overwhelm the market.
3. Ticker Tape Trading: Market data, such as quotations and volumes, may include a wealth of information that is not consciously included in the data itself. Computers can gather information that has not yet made it to the news displays by tracking the flow of quotations.
If the public has access to all relevant quotation and volume data, such techniques are legal.
One of the most rudimentary high-frequency trading tactics, filter trading, includes keeping an eye on many stock market shares for price or volume movements that are substantial or unexpected.
There are several ways to trade based on announcements and news. An order to purchase or sell would then be generated by the software. A common goal of tick trading is to identify the beginnings of major market orders.
For example, if a pension fund orders a large number of units, the price will climb because of the increased demand. An arbitrageur may be able to benefit from this by purchasing the security and then selling it back to the pension fund. Since the advent of specialized trade execution firms in the 2000s, this method has gotten increasingly challenging.
4. Event Arbitrage: Predictable short-term reactions in a limited group of securities are triggered by certain recurrent occurrences. For short-term gains, high-frequency traders take advantage of the predictability of the market.
5. Statistical Arbitrage: Trading methods that take advantage of short-term fluctuations in statistical correlations between assets are another high-frequency trading strategy.
Equities, bonds, futures, foreign currency, and other liquid instruments are all subject to statistical arbitrage, which occurs only at high frequency. Traders must note that there is covered interest rate parity which can be found especially in the foreign exchange market.
This can establish a link between the prices of domestic bonds and those denominated in foreign currencies. The spot price of a foreign currency and a forward contract on a foreign currency may also be included in such schemes. High-frequency trading enables arbitrages involving more than four stocks to be performed.
6. Index Arbitrage: As a result of their shifting weights in indexes, index tracker funds are obligated to acquire and sell huge amounts of securities, which are exploited by index arbitrage.
Buying and selling assets ahead of the tracker funds is possible if an HFT business has access to and the ability to interpret information that forecasts these movements, offering several arbitrage opportunities.
7. News-Based Trading: Electronic text versions of company news are accessible from a variety of sources, including commercial suppliers such as Bloomberg, public news websites, and Twitter feeds.
Automated systems can recognize business names, keywords, and sometimes semantics to execute trades based on breaking news before human traders can interpret it.
8. Low-latency trading: A distinct class of high-frequency trading tactics is dependent on ultra-low latency direct market access technologies. Computer scientists use these tactics to achieve microscopic benefits in arbitraging price disparities in a specific asset traded on many marketplaces concurrently.
9. Order Properties Strategies: High-frequency trading algorithms may make use of features generated from market data streams to discover orders issued at less-than-optimal pricing.
These orders may provide an opportunity for high-frequency traders to benefit from their counterparties. These characteristics include the age of an order and the sizes of the displayed orders.
Which Algorithm Should You Use?
This will depend on every trader and their unique trading objectives and needs. Most high-frequency traders make use of either Statistical Arbitrage or Market Making algorithms and strategies.
HFT is a subset of algorithmic trading, and ultra-high-frequency trading is included in HFT. These complex algorithms act as intermediaries between buyers and sellers, with HFT and Ultra HFT allowing traders to profit on tiny price disparities that may remain for a minuscule amount of time.
Computer-assisted rule-based algorithmic trading places orders via the use of specialized programs that make automatic trading choices. AT divides big orders into smaller ones and puts them at various times, as well as managing trading orders once they are submitted.
Large-scale orders, which are often placed by pension funds or insurance firms, may have a significant influence on stock market prices. AT seeks to mitigate this pricing effect by dividing big orders into several tiny transactions, so providing traders with a price edge.
Additionally, the algorithms dynamically manage the timeline for submitting orders to the market. These algorithms ingest real-time, high-speed data sources, recognize trading signals, determine optimal price levels, and then execute trade orders when a suitable opportunity presents itself.
Additionally, they can identify arbitrage possibilities and trading based on trend tracking, news events, and even guesswork.
Which Software and Programming Languages are used in High-Frequency Forex Trading?
Even the Java applications often used for basic day trading are more difficult than the real software that enables high-frequency FX trading feasible.
A wide range of programming languages is used to create high-frequency trading algorithms: Quantitative analysis is common in Python, whereas data and statistical analysis are common in R, and quicker program architectures are possible in C++.
Others will utilize MATLAB or C#. To have the edge over other high-frequency trading systems, the software creator must be able to create something quick enough to do so.
What are the Advantages of High-Frequency Forex Trading?
Large quantities of securities may be traded at high speeds to take advantage of the smallest price changes, thanks to high-frequency trading. Using this strategy, institutions may reap huge profits from bid-ask spread arbitrage.
Market and exchange scanning are possible using trading algorithms. There are additional trading options, such as arbitrating small price variations for the same item traded on separate exchanges.
In the eyes of many supporters of high-frequency trading, it improves the market's liquidity. As transactions are done quickly and the number of trades rises, HFT boosts competitiveness in the market.
Price efficiency improves due to lower bidding/offering spreads because of higher liquidity. Because there is always someone on the opposite side of a trade in a liquid market, there is less risk.
The price a seller is willing to sell for and the price a buyer is prepared to pay will become more closely aligned as liquidity grows. A stop-loss order, which ensures that a trader's position closes at a set price and prevents additional loss, is one strategy for reducing risk.
What are the Disadvantages of High-Frequency Forex Trading?
Regulators, financial experts, and academics are divided on whether high-frequency trading is a good thing. While some high-frequency traders keep a small amount of money in their portfolios overnight, they often only hang onto their positions for a short time before selling them off.
Consequently, the Sharpe Ratio, or risk-reward ratio, is quite high. Investors that use a long-term approach have a far better return-to-risk ratio than those who do not. When it comes to high-frequency trading, a fraction of a penny is all they need to earn money throughout the day, which raises the risk of making a large loss.
“Ghost liquidity” is a key drawback of high-frequency trading. Because the securities are only held for a brief period, HFT opponents argue that the “liquidity” produced is not genuine.
The security has already been exchanged several times by high-frequency traders before it can be purchased by an ordinary investor. Because of HFT, a lot of liquidity has evaporated before the typical investor placed an order.
High-frequency traders such as prominent financial institutions are also thought to make money by harming smaller market participants, including several smaller financial institutions as well as retail traders and individual investors.
Finally, high-frequency trading has been related to greater market volatility, if not outright collapses. Some high-frequency traders have been in trouble for unlawful market manipulation, including spoofing and layering, by regulators.
During the Flash Crash of 2010, it was proved that high-frequency trading significantly contributed to the extreme market volatility.
Who should use High-Frequency Forex Trading?
High-frequency trading is more suited towards large investment banks, hedge funds, and institutional investors who employ powerful hardware and robust software to carry out multiple orders at high speeds.
How to Start High-Frequency Forex Trading
To start with high-frequency forex trading, traders must:
1. Find the right broker
2. Get a thorough education on HFT
3. Purchase Software
1. Find the right broker: This is the first step involved and requires that traders identify an appropriate broker that can accommodate HFT, such as IG Group, Forex.com, and Interactive Brokers.
These brokers accommodate high-frequency traders and offer trading conditions, trading software, and solutions that are aligned with the needs of clients.
2. Get a thorough education on HFT: Before starting with HFT, traders must ensure that they have the necessary knowledge and skill to participate. Traders can read journals, books, blogs, and other educational materials to learn more. Traders can also attend courses and sign up for financial advice from professionals.
Once traders are more equipped for HFT, they can start exploring the algorithms that they want to use according to their individual preferences, needs, and any financial restrictions.
3. Purchase Software: Once traders are familiarized with how they want to participate in HFT, they can explore their software options, application programming interfaces (APIs), and other components to get them started.