High-Frequency Trading Explained: What It Is + Strategies

If you’ve been trading for a while, chances are you’ve heard of high-frequency trading (HFT). You may not know what it is or what it does, but you know there are trading robots out there competing against you. 

These robots are the reason listed stocks seem to hover at certain price ranges. It’s as if they’re floating in another stock market dimension.

Their actions are invisible to you for the most part, but you know they’re there. And you wonder where they’ll show up next. 

Today I’ll help you solve the mystery. We’ll get into the nitty-gritty of high-frequency trading algorithms. I’ll show you how they work, the different strategies they use, and why they might help you out once in a while.

Hard to believe? Read on and decide for yourself. We’re about to uncover the secrets of high-frequency trading strategies. 

What Is High-Frequency Trading?

High-frequency trading is the process of buying and selling large, high-speed orders. Powerful computers use proprietary algorithms to make quick trades.

The platforms allow traders to scan many markets and place millions of orders in a matter of seconds. Hedge funds, investment banks, and institutional investors buy them.

Their software can scan for shifting trends in the market before they happen. This, combined with super high-speed transactions, provides a strong advantage.

High-frequency trading strategies capture important financial data in record time. And they act on that information with intelligence.

How High-Frequency Trading Works

There isn’t one way to define high-frequency trading. The Securities and Exchange Commission (SEC) describes it according to five characteristics:

1. Use of extraordinarily high-speed and sophisticated programs for generating, routing, and executing orders.
2. Use of co-location services and individual data feeds offered by exchanges and others to minimize network and other latencies.
3. Very short time frames for establishing and liquidating positions.
4. Submission of numerous orders that are canceled shortly after submission.
5. Ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight).

High-frequency trading algorithms present a challenge to the average retail trader. They operate on a complex level the human mind can’t match.

That’s why it’s so important for traders to study hard and find their edge in the markets. 

Is High-Frequency Trading Profitable?

The short answer is yes, it can be. That’s why institutions invest in high-frequency trading software. It’s a direct way to give themselves an edge in the markets. But it’s not simple.

Their machines are highly sensitive to momentum shifts. This allows them to place huge orders in seconds at ideal bid-ask spreads. 

The bid-ask spread is the difference between what a buyer will pay for a stock and what a seller will accept for it. Sometimes the difference is noticeable — especially with large-scale orders. 

These price shifts happen several times in a trading day. This gives the program many opportunities to capitalize on the changes. 

Sometimes they engage in what’s called front-running. This involves seeing and racing ahead of a large client order (like an index fund) to buy the shares first, then selling them back at a profit.  

With sizable capital and a good trading algorithm, there’s no limit to potential gains. In theory, of course.

How Much Money Do High-Frequency Traders Usually Make?

How much money a high-frequency trader makes depends on education and experience. 

Hedge funds and high-frequency trading firms hire people with Ph.D.s in math, physics, computer science, or engineering. According to efinancialcareers.com, they won’t hire someone who only has a bachelor’s degree.

If you develop high-frequency trading algorithms for a firm, you can expect to earn $133,000 to $135,000 your first year, according to the site. The following year, that should rise to $249,000 to $291,000. And if you’re one of the best, you could easily see $400,000 to $1 million a year, according to efinancialcareers.com.

That’s a pretty sweet chunk of change. But there are no shortcuts with this job. You have to study your butt off to get to the big leagues. And high-frequency trading is not for everyone.

If you’d rather hone your retail trading strategies, it helps to have a team behind you. The SteadyTrade Team can show you the ropes. You’ll get hands-on mentorship, twice-daily live webinars, and access to a great community of dedicated traders. Sign up for the SteadyTrade Team here! 

Is High-Frequency Trading Illegal?

Most forms of HFT are legal and the strategies are pretty common. You could argue, for example, that a quick buy and sale of orders is equivalent to scalping. 

What sets HFT apart is execution speed and the ability to analyze large amounts of data. This requires a high up-front investment in technology and talent. 

And things are legal … until they’re not. And the change usually comes as the result of an event that causes serious damage. 

The software involved in high-frequency trading strategies makes it difficult to set laws against the practice. A law would have to specify which HFT software is and isn’t allowed. Where do you draw the line?

Some people argue that HFT algorithms support retail traders. They say the algorithms help to lessen the bid-ask spread in volatile markets. 

Cutting down the bid-ask spread keeps prices more efficient. And it helps traders who want to enter and exit positions quickly. The lower the bid-ask spread, the less risk of slippage. 

Slippage is the difference between the expected price of a trade and the price at which it executes. It can increase in volatile markets. And it can occur when you put in a large order but there isn’t enough volume to support it. 

Slippage takes small bites out of your profits, and that can add up over time. That’s why it’s so important to make sure you’re in a liquid stock before you trade. 

High-Frequency Trading Strategies

Hedge funds and trading firms use many different HFT strategies. They all rely on advanced technology to gain an edge in the markets.

But not all strategies are the same. There are nuances to how these algorithms find and extract their piece of the trading pie.

Market Making

Market makers trade large orders that profit from differences in the bid-ask spread. Often, a market maker belongs to a firm and can use high-frequency trading software. 

But they also may rely on relationships with brokers to carry out their trades. When they do, the transactions are less time-sensitive. 

 

Quote Stuffing

High-frequency traders use quote stuffing to manipulate markets. They quickly enter and withdraw large orders to create market confusion.

The intent is for HFT algorithms to capitalize on the confusion. Quote stuffing is illegal and subject to disciplinary action.

Ticker Tape Trading

Ticker tape trading involves scanning market data for quotes and volumes. Computers can scan a flow of quotes to extract information that hasn’t yet reached news screens. The quote and volume information is public, so this strategy is legal.

Yet because computers have the advantage of speed, they’re able to scan a huge amount of data very fast. This means they can capitalize on the impact of a news catalyst in less than a second.

Event Arbitrage

Sometimes predictable, repeating events create predictable, short-term responses in certain securities.

One example is when a Federal Reserve governor talks about keeping rates the same. Each time that happens, it tends to boost tech stocks. High-frequency traders take advantage of the predictability to gain short-term profits.

Statistical Arbitrage

Statistical arbitrage exploits the predictable, temporary differences from steady statistical relationships between securities. It applies to any liquid security — equities, bonds, futures, currencies…

The benefit can come from the difference in price between a bond, its price in a foreign currency, the price of the foreign currency itself, and the price of a future contract on the currency.

Index Arbitrage

Index arbitrage capitalizes on index tracker funds. The funds have to buy and sell large volumes of securities to match the changing weight of indexes.

A high-frequency trading firm can access information that predicts these changes. They buy the securities before the tracker funds do, and sell them back at a profit.

News-Based Trading

HFT computer programs can scan many news sources, from news outlets to public websites to Twitter. They analyze the information much faster than a human brain can.

The systems are highly intelligent. They can process company names, relevant keywords, and even nuances in the news. This increases their odds of making a profitable trade.

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Low-Latency Strategies

Low-latency strategies rely primarily on ultra-fast speed. The technology takes advantage of the smallest price differences in a given security — as it trades in different markets.

Since 2011, this technology has relied on microwaves instead of fiber optics to send data. Microwaves travel through air with a less than 1% speed reduction when compared to the speed of light. By contrast, fiber optics travel over 30% slower. It’s amazing what technology can do!

High-Frequency Trading vs. Algorithmic Trading

It’s easy to think high-frequency trading and algorithmic trading are the same. They’re both controlled by super-smart robots. But there are some key differences. 

High-frequency trading is a type of algorithmic trading. But there’s more to algorithmic trading than HFT.

High-Frequency Trading

HFT uses computer algorithm models to achieve its goals. The primary purpose is to gain an advantage in the market through large and fast trades. Being lightning fast is a priority.

High-frequency traders aim to make money by taking advantage of the tiniest, fractional gains that occur when prices fluctuate. And they use large orders to make them count. Their algorithms also help them make sure they have priority access to the most important data.

Algorithmic Trading

Algorithmic trading often has a longer time horizon than HFT. The algobot’s concern is execution at the best possible price. It places orders that are instant and accurate, but not necessarily short-term holds.

These bots can process information from many markets at once. And they optimize for the lowest possible transaction costs.

They’re a great way to reduce the manual and emotional errors human traders often make. They usually focus on statistically profitable, longer-term holds. They can also backtest historical and real-time data.

High-Frequency Trading Companies

HFT firms often operate in secrecy. After all, knowledge is power. You don’t want a competing firm to find out how successful you are and why. 

But there are a few high-frequency trading firms you’ll come across again and again. When you’re making tons of money, someone’s bound to find out. 

It’s not always fun and profits. We all found that out when Citadel LLC got wrapped up in the Gamestop Corp. (NYSE: GME) controversy with WallStreetBets retail traders.

And sometimes the robots get out of hand. That’s what happened to Knight Capital Group a while back. A program they intended to deactivate went rogue instead. 

The program sent out orders that cost the firm $10 million per minute, according to news reports. It took 45 minutes of digging through eight sets of trading and routing software to find the issue and stop it. Meanwhile, NYSE officials were trying to figure out what was going on. And the SEC got inundated with emergency email alerts.

It’s amazing what can happen in the blink of an eye. That’s technology for you. And there’ll be more of it coming in the future.

HFT companies won’t go away anytime soon. Neither will retail traders. It’s a brave new world, and we’ll have to coexist. That includes duking it out every once in a while to see who’s boss.

If you want to see how retail traders find an edge in the markets, tune into my LIVE Pre-Market Prep sessions. I’m there for you every trading day at 8:30 a.m. Eastern time.

High-Frequency Trading: The Bottom Line 

For as long as advantages exist, people will debate their fairness. High-frequency trading is no different.

Some people argue that HFT is too big and too fast to play fair. And that it takes advantage of expensive and sophisticated software to exploit the markets.

Much like market makers, high-frequency traders can profit from tiny price fluctuations. They get a few cents per share for creating stock liquidity. That type of gain is only worth it if you can place huge orders over and over again.

People in a different camp know that people have always profited from speed in the markets. That’s nothing new. So at what point do you decide what’s fair and what isn’t?

Some also believe high-frequency traders help keep prices stable and reduce volatility. Sometimes bid-ask spreads can get out of hand. If there’s no liquidity, stocks can get stuck with large spreads for a while.

High-frequency traders can swoop in and get a stock moving again. This creates a steady and somewhat predictable price range.

What do you think? Are high-frequency traders friends or foes to retail traders? Should there be limits on HFT? Sound off in the comments below!