High Frequency Trading

High-frequency trading (HFT) is a method of automated investing that uses algorithms to act upon pre-set indicators, signals and trends. It’s commonly used by big investment banks and market players who combine large order volumes with rapid executions. Read on for the best HFT brokers and how to get started.

This article will guide you through what high-frequency trading is today, where it may go in the future, and its potential benefits and disadvantages. It will also explain the key strategies employed by high-frequency traders, as well as the infrastructure required to get started and where to find educational resources and software.

Best HFT Brokers

Forex.com boast a global reputation. Regulated in the UK, US and Canada they offer a huge range of markets, not just forex, and offer very tight spreads and a cutting edge platform.

Whilst most high-frequency trading firms use institutional brokers, some platforms and providers accept retail traders. Of course, algorithmic and high-frequency trading strategies have certain requirements, so it’s important to do your research.

When looking for the best brokers, consider:

  • Latency – Speed is everything in the high-frequency trading game, so look for brokers offering the tightest data latency to minimise time delays.
  • Fees – High-frequency traders may already benefit from competitive fees in return for providing market liquidity, but the top brokers can help accentuate those margins further.
  • Automation – The best brokers offer extensive automation and integration capabilities to minimise cumbersome manual trading.

What Is High-Frequency Trading?

Despite being around for decades, high-frequency trading has no formal definition, even for regulatory agencies. Instead, high-frequency trading can be described as an approach to equities and forex trading that involves using cutting-edge technology and sophisticated algorithms to perform a large number of incredibly fast trades.

Co-location services and data feeds from exchanges and others are often utilised to reduce network and other latency issues. Traders aim to close the day close to flat, so with zero substantially hedged overnight positions.

History

Early Days

High-frequency trading, as it is today, has been carried out since Instinet, the first electronic exchange was developed in 1967. However, algorithmic trading did not really take off until the National Association of Securities Dealers Automated Quotations (NASDAQ) implemented technology that supported automated investing within their electronic exchange.

By the early 2000s, high-frequency trading accounted for less than 10% of equity orders, though this rose through the decade to its peak at 61% of the US trading volume in 2009.

This rise can partly be attributed to the Regulation National Market System (RegNMS) in 2005, which stated that orders in the US must be executed at the exchange with the best prices. RegNMS allowed traders to spot trends in one exchange and capitalise on them before the price effect ripples to other exchanges. This led to massively increased competition and HFT grew exponentially, particularly with a lack of regulation.

Global Growth

Though largest in the US, high-frequency trading went global in the early 2000s, with Asian countries such as Japan, Korea and Singapore taking the lead alongside New Zealand, Australia and the UK.

The effects of the financial crash, coupled with the implementation of some regulation measures by the Financial Industry Regulatory Authority (FINRA) in America and the European Securities and Markets Authority (ESMA), led to a decline in the share of high-frequency trading, which now stands closer to 50%.

Financial agencies from other global markets also began to regulate HFT, implementing new laws and rules to limit the impacts of high-frequency trading software. These markets include the National Stock Exchange (NSE) in India as well as some in the Philippines, Malaysia, Canada and the Netherlands.

How Does High-Frequency Trading Work In 2020?

There are several ways that high-frequency traders can take advantage of their edge and make money, be it by capitalising on pure speed or marrying that with a deep understanding of the markets and global infrastructure.

Arbitrage

Arbitrage involves taking advantage of price differences on an asset over several markets. For example, a trader might see a price dip for the Euro on the London Stock Exchange and buy a large quantity. Simultaneously, they would sell Euros on the New York Stock Exchange, where the price is still higher, and make money through the price differential.

Arbitrage is not a new concept; hundreds of years ago horse-drawn carriages would race between New York and Philadelphia, exploiting similar opportunities on commodity prices. However, it has recently become more prominent and technological advancements allow it to be more profitable.

Market Making

Market making is a common strategy option, often carried out by big brokers and firms. The strategy involves improving the liquidity of the market by placing lots of bids and asks in the same market, helping traders find matching price quotes and making money through the asset’s spreads.

High-frequency trading firms also take this approach, carrying out the same process but at much greater speeds. This can have the effect of pushing out the larger market makers and, since these firms tend to be much smaller, they are less reliable and secure as a source of liquidity in the long term.

Pinging

Pinging is a way to find large orders that have been placed by big firms and hedge funds. The process seeks out segmented orders by placing lots of small orders inside the bid-ask spread. If these orders are met, then there is likely a large, hidden order and the algorithm can then trade with lower risk, as it has deeper information about the market.

News-Based

High-frequency traders use their technological and locational advantages to rapidly scan news releases with algorithms and sometimes co-locate computers near outlet servers to receive news first. The algorithms can gauge whether the news will have positive or negative effects and place large orders before other traders react.

Key Concepts

Co-Location

Delays in communication due to internet speeds, 5G, distance, order processing and order routing can impact profit margins. Co-location is a way to minimise latencies by establishing a computer as geographically close as possible to the data source.

On this computer, the algorithm would run, and orders would be processed and made. Many exchanges rent physical space in their data centres, providing direct connections into the server and shaving off vital time.

Dark Pools

Dark pools of liquidity are essentially private markets that cannot be accessed by most traders, unlike public exchanges such as the NYSE and LSE. Dark pools play a role in allowing block trading, which stops very large orders from big firms, such as KCG, having sharp impacts on public markets.

Dark pools have an inherent lack of transparency, which can be attractive to high-frequency traders as certain practices have become harder to carry out legally or profit from in the public markets. High-frequency traders often use dark pools to work their more exploitative strategies, such as front-running.

Technology

Often likened to an arms race, high-frequency traders need the latest and best infrastructure to fight for every millisecond, or even nanosecond, advantage. As such, some of the software and open source technology that is used can be complex, ranging from Xilinx field-programmable gate arrays (FPGAs) and bespoke graphics processing units (GPUs) to deep machine learning, microwave networks and quantum computing.

Algorithms

The basis of high-frequency trading can be thought of as a more sophisticated version of MT4’s Expert Advisors (EAs) offered by day trading brokers, such as eToro. The algorithms behind high-frequency trading take market data, perform analysis and use indicators to signal an opportunity which the bot will use to make an order.

Creating algorithms can be more complicated than simpler forex day trading strategies written in Java. Often, using software calls upon a range of programming languages, with application programming interfaces (APIs) to integrate them.

Python is the most common language for quantitative analysis and trading, whereas R is a widely used language for data and statistical analysis and C++ is a complex language that allows for better and faster program structures. Some high-frequency traders also use other languages, such as Java, Matlab and C#.

Cryptocurrencies

High-frequency trading is not limited to use with stocks and forex markets; the concepts behind it can also be used with cryptocurrencies, such as Bitcoin. Cryptocurrencies are decentralised currencies, with no physical markets and data centres, instead operating through a network of servers.

In order to gain a co-location advantage similar to that with traditional markets, high-frequency traders use cloud-based virtual private servers (VPSs), which allow them to run their algorithms directly from the internet. This practice is extending to more and more ETFs and companies around the world, including India, Amsterdam and London.

Pros And Cons Of High-Frequency Trading

Whether or not high-frequency trading is good or bad for the markets is a matter of great contention; the debate has been raging for years and is spurred on by scandals with firms such as UBS, Goldman Sachs and Robinhood.

Pros

There are many proponents of high-frequency trading, who claim it can benefit the liquidity and stability of the markets. The rapid market-making approach of many HFTs can add more liquidity to the market, allowing regular traders to find matching orders and move their money faster. This is an improvement of the efficiency of price discovery, which tightens spreads and can reduce arbitrage opportunities. Also, rather than attempting to beat the ultra-fast robots, traders can use other techniques to benefit.

Cons

However, some believe that high-frequency trading harms the market, making it unfair to those who do not have the capital, hardware and location to compete in the same game. Furthermore, it can increase the market’s volatility with its rapid response to fluctuations and makes the market more exposed to flash crashes. This can happen when the algorithmic nature and ultra-fast speeds cause a massive sell-off, which damages markets. And for those wanting to compete with the top 10 high-frequency trading firms in New York, for example, the transaction costs and investment required can be a serious barrier.

Overall, there is no doubt that high-frequency trading opens opportunities for those with the knowledge, hardware and capital to take advantage of it.

Regulation

High-frequency trading has few governing regulations and rules from the likes of the FCA, for example. One key reason for this is that there is no universal definition, rather only general characteristics.

ESMA

In the EU, ESMA’s Markets in Financial Instruments Directive II (MiFID II) has helped to make high-frequency trading definitions more transparent. Firstly under MiFID 2, all investors, bar a few specific exemptions, must be authorised by financial authorities.

Secondly, investors using high-frequency models must store time-sequenced records of their systems, algorithms and trades for up to five years. This added transparency helps to reduce the opportunities of illegal market abuse by high-frequency traders and improves the agency’s ability to spot abuse through volume statistics and analysis.

FINRA

The Financial Industry Regulatory Authority (FINRA) in the USA is responsible for the regulation of the American markets and has introduced similar regulations, though with a greater emphasis on effect mitigation. The rules limit the way firms can conduct and report on order flows and books, reducing the opportunities for spoofing, fictitious quoting and improper influence on the appearance of a market’s activity and price.

The regulations also dictate that firms need to emphasise development and testing before implementation, along with compulsory risk management standards to reduce the likelihood of technological failures impacting the markets.

Whilst not illegal, if you are thinking about starting to build your own high-frequency trading system, make sure you understand the tax implications in your jurisdiction.

How To Start High-Frequency Trading

High-frequency trading is dominated by two types of traders: large firms with serious capital and small teams of specialists with sophisticated software programs. There are, however, options for individuals and beginners, retail investors, and small firms to use a high-frequency trading strategy to generate a salary.

Firstly, some companies have begun democratising high-frequency trading so that it is an accessible option for newer traders and smaller investors. Alpha Trading Labs, a US enterprise, offers retail traders the opportunity to use their HFT systems and computers for a commission. Other firms from around the world, including London, India, Hong Kong and Zurich, offer similar high-frequency trading services to clients.

Choosing an HFT Broker and Trading Platform

For traders who want to start with high frequency trading the choice of broker and trading platform is very important. Few brokers offer trading platforms that are suitable for high frequency or high volume trading, but the ones who do can be found in our  list of the best HFT brokers.

Resources

If you want to begin algorithmic and high-frequency trading engineer jobs, be it in an office or from home, you can use a range of online resources to build the required knowledge of how it all works.

There is a myriad of handbooks, podcasts, blogs, journals and online PDFs of algorithmic and high-frequency trading with information and tutorials on its potential salary and underpinning modeling skills in finance.

There are also numerous websites providing online training courses in quant analysis and high-frequency trading for dummies, with a range of resources and tips, such as using an open-source boosting framework like XGBoost to improve the volume of trades executed per second.

Once the concepts are understood and the knowledge to write an effective algorithm is amassed, software is needed. There are a range of platforms and algorithm builders designed for high-frequency trading, such as QuantConnect. You will also need to use application programming interfaces (APIs), which allow individual software pieces to communicate and can either be written from scratch or bought from providers like AWS.

There are even documentary films and movies on the topic available, as well as detailed research papers with the meanings of key tools and databases explained. We’d also recommend the Flash Boys: A Wall Street Revolt book by Michael Lewis, for those looking for high-frequency trading 101s.

Final Thoughts On High-Frequency Trading

Even though the ramifications of high-frequency trading are unclear and hotly debated, there are undoubtedly some clear-cut advantages. The technique no doubt ushered in new realities for traders, markets and regulators, offering large returns for those able and willing to make big investments. And interestingly, high-frequency trading is gradually being made available to retail investors through software packages and commission-based services.

FAQ

What is high-frequency trading?

High-frequency trading is a form of automated trading that uses sophisticated algorithms to execute a substantial volume of trades ultra-fast.

What are the best high-frequency trading strategies?

There are a number of common high-frequency trading strategies used by top firms and specialists. Techniques include arbitrage, market making, pinging, and news-based systems. Details of all can be found in this article.

How do I get started high-frequency trading?

Before you can start high-frequency trading, you need to understand the technology and infrastructure utilised. Read our HFT tutorial and you’ll be off to a great start. There are also a host of other online tutorials, books, PDFs and handbooks that detail high-frequency trading strategies and essential information. We also have a list of the best high frequency trading brokers.

What is the salary of high-frequency trading jobs?

The salary of high-frequency trading jobs varies. If you work for top New York firms and hedge funds, salaries can stretch into the millions. Of course, there are plenty of high-frequency traders and engineers that earn much less.

Is high-frequency trading easy?

High-frequency trading is difficult. It requires a huge investment in software and infrastructure, plus a detailed understanding of financial markets. As a result, the high-frequency trading market has traditionally been dominated by large firms and hedge funds. With that said, online brokers and technological improvements are making high-frequency trading more accessible to retail traders.