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High Frequency Trading: Pros and Cons

High-Frequency Trading Pros and Cons
author Written by
Rex John Walsh
author Fact checked by
Sangram Mohanta

Last Updated on June 3, 2024 by TOP FOREX BROKERS REVIEW

As a forex trader, you need to constantly look for opportunities that help you to reach your goals. HFT or high frequency forex trading is something that can boost your profits from the market. Automated trading of high-order volumes within short liquidation windows is possible on this algorithmic platform. 

Traders and investors alike have been captivated by high-frequency trading. This method uses forex algorithms and robust computer systems to place numerous trades in a very short amount of time, often even seconds.  

The goal of HFT is to gain a small amount of profit from each trade, it can even be a fraction of a cent. But it’s a win-win situation most of the time. 

Curious to know more? Let’s dive in!

What Is High Frequency Forex Trading?

High frequency forex trading is an algorithm-based trading system that uses extremely complex technology to execute a high order volume within milliseconds. 

Traders use HFT to analyze multiple market trends and look for arbitrage scopes to send out a large number of buy orders within seconds, which increases the bid-ask ratio.

HFT is popular for cutting down work hours to only 10 milliseconds while generating high turnover rates. Though this type of trading only generates a small profit per trade, for example, a cent or less, it still results in huge profits due to millions of transactions occurring within the blink of an eye. (Source)

It was first introduced and popularized by the New York Stock Exchange after the 2008 financial crash, offering incentives to investors to add liquidity to the market.

Famous HFT Incidents

Market crashes and investment losses are quite common in the HFT world. However, two major crash incidents shook the market and resulted in serious losses for the companies. 

The 2010 Flash Crash

On May 6th, 2010, the Dow Jones Industrial Average (DJIA) lost 1000 points within 30 minutes, losing $1 trillion in market value. It was a plunge of over 9%, which happened in the shortest period anyone has ever witnessed in the last few decades.  

The company said that it happened due to malfunctions in their new software that led to selling all of their stocks within a few minutes. They recovered most of it that day. 

However, the investigations accused Waddel & Reed of a $4.1 million sell order. According to an article by Forex.com,  this company was using an automated algorithm strategy to trade e-mini contracts.  

Knight Capital's $440 Million Collapse 

In 2012, Knight Capital Group faced a loss of $440 million within 45 minutes due to a trading platform glitch. Due to software malfunction, the company sent out enormous sell orders to the market.

A New York Times report claims that shares of Knight Capital fell almost 32% on that day, which eventually went down to 63% the next day.  

Pros Of High Frequency Forex Trading

The minimal latency of HFTs can bring multiple benefits to your trading. A few of the major advantages that traders get are mentioned below.

Fast Execution Helps Rapid Decision-Making

One of the main focuses of high-frequency trading is making precise and quick profits from small price movements. Traders may seize fleeting market opportunities with pinpoint accuracy before more traditional market participants react.

Algorithm-Based Procedure 

High frequency trading bot forex and other systems rely on algorithms to facilitate fast decision-making and remove emotion from trading. Traders can now make data- and market-driven decisions with the help of predetermined algorithms, doing away with the influence of human emotions like fear and greed in traditional trading.

Improvement Of Market Liquidity

Those who support HFT argue that it significantly adds to market liquidity. Reduced bid-ask spreads are a result of increased liquidity that occurs due to traders' continual buying and selling. This increased liquidity has the potential to lead to more efficient markets and lower trading costs for all parties involved.

Tighter Bid-Ask Spreads

The role that HFT plays in narrowing the spread between ask and bid prices is one of its most prominent advantages. Due to the constant presence of high-frequency traders, the spread between buying and selling prices is considerably thinner.  

Enhanced Price Discovery

As new information may be incorporated into market pricing more quickly, HFT can aid in price discovery. Fast transaction execution allows for efficient adjustment, which in turn makes market prices more reflective of the true value of financial instruments.

Cons Of High Frequency Forex

HFT has opened more doors to significant profit than ever for traders and institutional investors. However, it didn't come without its unique challenges. 

Recent incidents and continuous issues related to volatility and liquidity have raised questions about ethics and their potential impacts on the market. So, some potential drawbacks arise, as mentioned below.

Unfair Market Access

Critics of high-frequency trading say that it gives bigger corporations unfair access to strong technology, which in turn makes market inequality worse. Since they have this leg up, they can "jump the queue" when it comes to receiving price data, which could result in better prices before other market players, especially retail traders, can respond.

Likelihood Of Manipulation

The liquidity created by HFT, which is sometimes called 'ghost liquidity,' is only there for a very short time, a few seconds. Since this liquidity is so transient, its detractors argue that it serves the market as a whole poorly.  

High Risk-Reward Ratio

The extremely high risk-reward ratio is a major negative for traders who use HFT tactics. Significant losses are more likely due to the huge positions taken and the short holding periods. Many high-frequency traders (HFTs) use stop-loss orders to automatically exit positions at certain loss levels to mitigate this risk.

Market Volatility And Crashes

High-frequency trading can cause more market collapses and volatility. As an illustrative case in point, the Flash Crash in May 2010 occurred because of HFT, which caused a sharp and unexpected decline in the market. 

The quick and automated aspect of HFT has worried European and American regulators. According to a Bloomberg report, Athena Capital Research LLC was fined $1 million in charges. They used $40 million to change the prices of thousands of stocks.

Unfair Advantage

HFT relies on high-frequency computer-based algorithms and complex technology. This is why it is not surprising to notice that the major players in the market are large HFT firms, banks, hedge funds, and institutional investors. With larger resources in hand, they have an edge over the smaller firms and individual traders. This creates an unfair advantage for larger funds and ruins market strategy for smaller investors. 

Regulatory Costs

This kind of technology is not easy to regulate daily. The high maintenance charges get hefty for retail traders, leading them to quit the market.

The Technology And Infrastructure That Underpin HFT

Complex technology and infrastructure are the most crucial elements of executing HFT. High-functioning computers, programming languages, AI software, algorithms, etc., are a few of the requirements on the long list that underpins HFT. 

  • Data Feed: High-speed data feed provides data such as market prices and trends in real-time through co-location or fiber speed. It provides analyzed algorithmic data to traders without any delay. The HFT market depends on low latency and this real-time data feed adds value to it. 
  • Algorithm: The algorithm is the core of HFT. Advanced algorithms and machine learning techniques analyze market data and score opportunities. Algorithmic techniques like statistical arbitrage,  market making, index trading, etc. are used to help HFT traders profit.  
  • Co-location: Large HFT corporations and hedge funds also use co-location to remove low latency. They often physically place their servers in the exact data centers of the exchanges. This decreases latency by reducing the time to execute orders.  
  • High-Speed Trading Platform: High frequency forex trading platforms are specialized platforms created for HFT. These platforms operate at a lightning speed that other regular platforms cannot. Such brokerage platforms are Interactive Brokers, TD Ameritrade, IG, Saxo Bank, and Capital.com.  
Is High-Frequency Trading Profitable?

If one has the correct tools, methods, and risk management policies in place, high-frequency trading (HFT) can be a lucrative chance to take. While some HFT enterprises have been quite successful, others have had a lot of trouble and even lost money. The potential win and loss is not always predictable in HFT.

Factors You Need To Consider For A Profitable HFT

Keeping some factors in mind may contribute to your HFT success to an extent. Some of them are: 

  • Advanced Technology Implementation: HFT mostly depends on using advanced technology. More effective capitalization of market possibilities is possible for firms that spend substantially on cutting-edge infrastructure.
  • Algorithmic Strategies: Companies that have strong algorithmic methods that can adapt to various market conditions have a better chance of making a profit. So, you need to think fast and execute the strategies faster. 
  • Market Conditions: Highly volatile and liquid markets are ideal for HFT. Faster trades are possible in more liquid markets, but high-frequency trading algorithms try to take advantage of price disparities caused by volatility.
  • Risk Management: The inherent risks of HFT can be better managed by companies that employ good risk management procedures, such as using stop-loss orders and setting suitable position sizes.

Wrapping Up

High frequency forex trading strategies can vary from time to time. It depends on individuals to stick to a plan that serves them the most. Due to the constant changes, you can’t stick to one plan all the time. Constant monitoring and changes are a part of gaining a good profit from HFT. 

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