High-Frequency Trading Explained

The world has seen rapid progress in information technology and computer science. Every day, a new invention, software, and device claims to minimise human work and perform impossible tasks. This progress can be seen in every sector of human life, and financial trading is no different. Traders and investors use high-end analytical tools and features offered on trading platforms for speculative trading and making profitable decisions. Another example of the high-tech revolution in the world of trading is high-frequency trading or HFT. 

High-frequency trading is used by banks, trading firms, and institutional investors to execute a large number of orders within seconds without any latency. The high-frequency trading process is mostly automated and minimises human touch and interaction with the actual trading orders. The technique of HFT has been praised and criticised because of its unique features and usage. The primary role of HFT is to exploit minute changes in the financial markets that may span up to milliseconds and execute orders accordingly to make a profit. 

The name perfectly explains the process and highlights its quick and robust nature. For HFT, detecting market changes, anticipating entry positions, setting up, and executing high-volume trades takes less than a second. This is possible because HFT deploys advanced computer algorithms and hardware to perform tasks and execute orders that humans cannot. HFT traders use these algorithms to profit from sudden market price movements. They can pre-set their preferences and fund the account, after which HFT algorithms do their magic.

High-frequency trading is ideal for holding short positions as it prioritises quick turnover. It is, therefore, highly associated with speculative trading because rather than trading on the intrinsic values of any share, it looks for sudden price fluctuations. HFT makes a profit from fractional price movements that may occur multiple times within a minute or less. 

It is important to mention that none of this comes without risk, and because this is an automated and quick process, a wrong execution cannot be stopped until it’s too late. There have been various scenarios in the past where high-frequency trading has caused ripples in the trading world and disturbed the order of things. This article will take you through everything you need to know about high-speed trading, common misconceptions about HFT, and much more.

What Is High-Frequency Trading?

High-frequency trading is a type of automated trading that works by deploying advanced algorithms and hardware. It minimises human touch in trades and is capable of executing a large number of orders within seconds or less. This algorithmic trading is capable of executing orders based on fractional changes in the prices of any assets. It is, therefore, very robust in performance. Here are some of the key factors of high-frequency trading:

• High-frequency trading combines three main components: exceptional trading market knowledge, advanced computing, and high-end hardware. Together, they form this revolutionary type of trading that works beyond human capacity. 
• Banks, trading firms, or institutional investors mostly use high-frequency trading. This is because a single trader cannot execute this type of trading. Simple trading parties cannot meet their requirements, even with large capital. 
• HFT executes tasks at unparalleled speed and thus has ultra-low latency. This means that orders are set up and executed within milliseconds. This is only possible if the internet connection is stable and high-speed. The orders are usually executed quickly because HFT can access trading venues directly. 
• HFT is capable of executing a large number of buy or sell orders multiple times within seconds. The final profit is an additive effect of all these orders. 
• HFT holds the position for a very short period of time, which may be milliseconds. It supports high turnover always. 
• HFT algorithms are highly intricate but sophisticated. They are designed to detect and act on the smallest price fluctuations in the market so they can perform tasks that may take humans a long time to comprehend. 

High-frequency trading slowly developed to its now-known glory after NASDAQ introduced electronic trading back in 1983. Since then, the execution time has gone down from minute to seconds to mili seconds. With the rapid progression today, we might even hear that the HFT can execute orders within nano-seconds, but it will take some time and surely a new era of high-end technology. Currently, HTFs use the following technology:

High-Speed Hardware 

HFT traders use specially produced hardware that is highly reliable and ensures rapid data processing. This hardware then ensures no latency between different device components when executing tasks.  

Sophisticated Algorithms 

Algorithms are the centrepiece of HFT, and their accurate development is key to making a profit. Algorithms are mathematical models that undergo much testing before they are used in actual settings. They are designed to detect even the smallest price fluctuations and patterns and predict price movements when possible. Due to these algorithms and their predictive abilities, high-frequency trading is closely related to speculative trading. However, speculative trading is just a part of HFT, which otherwise has a lot of features to offer. 

Direct Market Access (DMA)

Most HFT work on direct market access, which means that to reduce any delays in connections between them and trading platforms, they directly connect their systems to stock exchanges or trading platforms via physical fires and connections. This allows them to work at incredibly high speeds and finish the job. 

Specially Optimised Networks

Finally, this is possible only if HFT have highly optimised network systems between different devices. This is done by using fibre optic cables and high-speed data transmission. 

We will see these technological aspects of HFT in more detail later in the article. 

How HFT Works

HFT works through a combination of mathematical models called algorithms, real-time market data analysis, and rapid execution speed. The main goal of HFT is not to hold a long-term position based on an asset’s value but to detect, anticipate, and exploit minuscule price changes and profit from them. Thus, HFT is known as algorithmic trading and is a technological marvel. 

HFT works successfully because of the following three components in its mechanism:

Algorithms

Algorithms are the basis of HFT as they direct the whole process. Algorithms are mathematical models developed meticulously and tested rigorously to execute needed tasks. They can be highly advanced and unique to the situation. In HFT, algorithms are the threads that hold everything together. The following are the tasks that algorithms perform in an HFT:

• Algorithms detect minute changes in the price movements, which are then used to execute orders. 
• They anticipate price fluctuations, buy and sell orders, and take profit orders within less than a second. 
• They accept real-time market information, interpret it, and act on its behalf. 
• Algorithms are very good at recognising patterns, for example, recurring price movements and correlations between different currency pairs, which algorithms use to their advantage. 
• The best thing about deploying algorithms in any technology is that they can be fitted in with guidelines that are religiously followed in all tasks. In HFT, algorithms are taught the trading guidelines through historical data, which are then thoroughly implemented.
• Algorithms can be highly automated, so the need for human intervention becomes non-existent. 

Market Data Analysis

For HFT to work efficiently, real-time market data and analysis are required. HFT can thus intercept and interpret this data to their advantage. Generally, the data includes price fluctuations, world financial news, market sentiment, and most importantly, the order book data. HFT utilise all this data to make decisions and execute orders through the algorithms. 

Execution Speed

High-frequency trading is high-frequency because of its execution speeds. Since 1983, this speed has been one of the most developed features of HFT and has now been reduced to milliseconds from minutes. HFT require such high speeds mainly because they exploit minute changes in price movements, which occur within seconds. So, to keep up with fluctuating market prices, HFT must keep their execution speeds at the highest. 

These three components collectively make up the mechanism behind high-frequency trading. Each component relies heavily on the other for a seamless execution of a high-frequency trading system. There is a whole lot of work and dedication that goes into making these three components. 

Key Players in HFT

As explained before, high-frequency trading cannot be executed by single or small groups of traders as the computational power, hardware, and capital needed to run HFT are far greater and more robust. This is why specific firms in the world specialise in high-frequency trading. These firms have their own algorithms, real-time market analysis, and high-speed hardware that make them key players in the market. Here we look at a few of them:

Virtu Financial

Virtu Financial is one of the biggest HFT firms in the world. It is located in the United States of America. Vincent Viola and Doug Cifu founded it as an electronic trading firm in 2008. Since then, it has made its name worldwide as a high-frequency trading firm. Virtu Financial operates in over 50 countries worldwide, allowing users to trade multi-class assets. 

After its IPO in 2015, Virtu Financial became a cornerstone firm for transparent trading and accumulated profits on most of its trading days. It is an important market maker and, most of all holds unbreakable trust with traders and investors. 

Citadel Securities

Located in Miami, Florida, Citadel Securities has around $35 billion of daily equity trades. This glorious financial institution was founded by Ken Griffin in 1990 and has seen unmatched business and clientele support since then. Today, it is one of the world’s largest holders of high-frequency trades. It operates in almost all asset classes and holds a key position in options and fixed-income markets. 

Tower Research Capital

Tower Research Capital, founded by Mark Gorton in 1998, is headquartered in New York. However, it is spread worldwide and employs more than 400 people. This firm is a prominent name in the HFT market and has dedicated teams developing high-end technology that aids in high-speed trading. 

DRW Holdings, LLC

DRW Holdings is a propriety firm founded by Mark Gorton in 1998. It operates across several asset classes and focuses on electronic trading, making it a key player in high-frequency trading. 

These are the few largest HFT firms in the world today. These firms have special units that work on developing algorithms and high-end hardware for the successful execution of HFT. Contrary to a famous misconception, not all traders can get associated with these firms to execute HFT. These firms have special criteria and guidelines for those who have access to algorithms and technology. 

Tools and Technologies in HFT

We have discussed using algorithms in high-frequency trading, but so much technology still goes into an effective HFT. There are specific companies and firms in the world that specialize in HFT technology. Here, we talk more about the tools and technology used in HFT:

High-Speed Internet Connection 

A high-speed internet connection is the beating heart of any HFT system, and rightfully so. Without it, no algorithm would work its magic, no input from real-world data, and no connection to the trading platforms. In HFT, the information gained in even microseconds is important. If the internet connection is slow or latent, the HFT will not be able to execute orders in time and may result in total loss. This is why a high-speed internet connection, which may be through fibre-optic cables, might work best. 

Real-Time Data Feeds and Analysis 

Real-time data feeds and analysis are important for a successful HFT system. Based on these feeds and analyses, the algorithms can judge and anticipate price movements.  

Real-Time Risk Mitigation

As real-time data feeds are necessary for HFT, real-time risk mitigation is also necessary. This can be done by specially tailoring the algorithm and secondly by careful monitoring of price fluctuations. 

Access to Trading Platforms

For high-speed execution of orders, the HFT system requires direct connections to trading platforms and stock exchanges. This connection will only be fruitful when the trading platforms work on high-speed networks and the Internet when receiving orders. 

Intricate Hardware Systems

For HFT systems to manage all the above loads, an intricate hardware system is required that allows the algorithm to perform the tasks in under seconds.

With the ever-changing landscape of the technological world, the above tools will surely progress and develop to unmatched heights in no time. 

Advantages and Criticisms of HFT

As with any technology, there are good and bad sides to high-frequency trading, which causes praise and criticism in the market. Here, we look at each of them in detail:

Advantages of HFT 

• The biggest advantage of HFT is the fact that it provides liquidity to the markets. HFT executes many orders multiple times within a second, keeping the market going. It buys and sells within a short period, which is the reason behind market liquidity.
• As HFT analyses and interprets real-time market data, it helps combat market discrepancies and identifies correct prices. 
• HFT systems increase market volume because they are constantly buying and selling. This activity benefits exchanges by generating capital from transaction fees. 
• HFT systems provide liquidity to the markets during volatile times, and without them, the market may freeze, and the prices may become destabilised.

Criticism of HFT

• The biggest criticism of HFT is that it causes market volatility in periods of uncertainty. 
• High-speed buying and selling orders cause price swings that are unwarranted. 
• Because HFT works on high-end algorithms and hardware, anyone deploying HFT has an unfair advantage over the market. 
• There are quite a few different scams associated with HFT systems. 
• HFT systems are also prone to cyberattacks because of network connections. 

These are a few of the most famous advantages and criticisms directed at high-frequency trading in the trading world today. As with any technological progressive system, HFT will raise some questions and help people in some ways.

HFT in Forex Markets

High-frequency trading is most prominently used in forex markets because small changes in currencies and currency pairs can bring much profit if acted upon quickly and with a large capital. To a normal human, the changes in currency pairs and acting accordingly can take a few minutes if the trader is well-experienced and in this time, the whole game may be changed. This is where the beauty of HFT systems comes in. HFT can anticipate, set up, and execute many orders based on real-time market data or simple speculation, which can make a decent profit. Also, HFT will place sell orders where necessary, all in seconds. 

This is impossible for a human to do so even with all the knowledge and capital. HFT is so efficient in forex trading because of its unmatchable speed, and humans cannot yet execute such levels of speed. Additionally, to execute such orders, a good amount of calculation is required. Computer algorithms are exceptionally good at it and showcase their abilities in forex markets. 

Common Misconceptions About HFT

There are many misconceptions about the workings of HFT and its expectations. This is one reason traders assume high profits from HFT and why it is highly criticized in some places. Here, we address the common misconceptions about HFT that may lead to unrealistic expectations and confusion. 

First and foremost, HFT does not guarantee consistent profitability. HFT may be comparatively profitable because it can execute a high volume of orders quickly, but that does not mean that it will consistently bring you profits. You are still at risk of loss, and so are the HFT firms. The firms, however, deploy exceptional risk mitigation techniques that save them from consistent losses. 

Secondly, every retail trader has access to HFT. This is untrue because such an intricate and computationally heavy system can’t be accessible to all retail traders. Only banks, special firms, and institutional traders have access to the infrastructure that is the cornerstone of high-frequency trading. 

Another popular misconception is that HFT is not speculative. HFT is speculative. The deployed algorithm uses real-world data to speculate price movements in most cases and executes orders based on mathematical calculations and world news. 

Lastly, there is a misconception that CFD trading is similar to HFT. This is incorrect. CFD and HFT trading methods are speculative but differ in the circumstances; thus, they are two separate ways. 

These are only a few of the misconceptions related to high-frequency trading. 

FAQs About HFT

What Is the Role of HFT in Speculative Trading? 

HFT systems play a crucial role in speculative trading. HFT uses high-end algorithms, hardware, and real-time market data to speculate and profit from minute price fluctuations across markets. HFT increases market volatility, which is key to speculative trading. 

How Do HFT Firms Operate? 

HFT firms use advanced algorithms, high-end hardware, and real market data feeds and analysis, which aid in executing orders that bring profits. All of this is done in seconds, which makes HFT time efficient, increases human touch and, consequently, decreases chances of human error. 

How Is HFT Regulated?

HFT is regulated by regulatory bodies and frameworks established by world administrations and governments. 

High-frequency trading or HFT, is a type of automated trading that works by deploying advanced algorithms and hardware. It minimises human touch in trades and is capable of executing a large number of orders within seconds or less. This algorithmic trading is capable of executing orders based on fractional changes in the prices of any assets. Banks, trading firms, and institutional investors use it. It combines three main components: exceptional trading market knowledge, advanced computing, and high-end hardware. Together, they form this revolutionary type of trading that works beyond human capacity.

It comes with associated risks and has its own set of advantages and criticism. It is surely a very interesting way of trading. With the ever-changing technological landscape, it will only get bigger and better. Still, in some cases, it begs the question of what it means for long-term position holders and the unfair advantage and control it has on the market. Before you think about taking up HFT as your new way of trading, we recommend you research the concept and all the technology behind it well and deeply.