What Is High-Frequency Trading?

June 1, 2024


What is high-frequency trading? If you’re asking this question, you may already have come across this controversial strategy that today’s traders are increasingly exploring. 

High-frequency trading uses algorithms to automatically trade high volumes at speed, but is it getting results? Being among the best prop trading firms in Chicago, Black Eagle Financial Group aims to help professional traders like you further improve their skills and knowledge. Let’s look at high-frequency trading’s latest developments so that you can decide whether to adjust your strategy.

Define High-Frequency Trading

Keeping traders informed about the latest trends helps them harness potential benefits—and avoid the drawbacks. The world has changed drastically, and so has trading. What was once a solely human-driven concept now centers around online trading tools, computer algorithms, and other wonders of the digital age.

Rather than relying on human intuition and effort like other trading routes, this new concept of high-frequency trading uses computer programs to execute a large number of orders within seconds (or even less). Sophisticated algorithms analyze market conditions at high speeds, using this information to execute multiple orders in an effort to achieve more profitable outcomes.

Increasingly available advancements in technology mean more traders are starting to employ this automated trading method, and why not? In theory, the sheer speed combined with the impressive number of markets the algorithm analyzes should allow you to find the patterns and act on them quickly. 

Strategies That Underpin High-Frequency Trading

The concept of arbitrage is important here. Arbitrage is when a trader buys and sells a security at two different exchanges and prices. The aim is to make a profit.

What is high-frequency trading? Profiting off mismatched market prices (arbitrage) is a common approach in this new trading method. However, with high-frequency trading, you’re letting an algorithm see those price differences and trade large volumes. 

Three primary arbitrage strategies might work with high-frequency trading: slow-market, dark-pool, and rebate arbitrage.

Slow-Market Arbitrage

Not all trading exchanges happen at the same speed, which means the prices vary. With slow-market arbitrage, traders use fast connections to gain a competitive edge (using varying data speeds and trading on many exchanges).

Dark-Pool Arbitrage

Unlike the data-heavy focus of slow-market tactics, dark-pool arbitrage exploits the price differences among dark pools (private exchanges that public investors may not access).

Rebate Arbitrage

Some stocks offer a rebate to buyers. With rebate arbitrage, buyers purchase a stock offering a rebate and then quickly sell it at the same price to profit from that rebate.

The Pros and Cons of High-Frequency Trading

What is high-frequency trading worth to someone who knows the ins and outs? This is a surprisingly versatile trading approach. That might be why everyone from individual investors to hedge funds and banks are using it to execute multiple orders in a short amount of time. 

Powerful computer algorithms are running the show, and like anything else that heavily relies on technology, high-frequency trading is no stranger to controversy. Could you use it to maximize profits and trading efforts? While you weigh the options, look at the pros and cons of high-frequency trading below.

High-Frequency Trading Pros: Speed, Market Liquidity

The most apparent advantage of high-frequency trading is the speed and simplicity of your trades. Execute transactions in mere seconds, and let this translate into an unprecedented number of order executions in the blink of an eye.

High-frequency trading also improves the market’s liquidity and stability. The algorithm sells an asset as soon as it hits a predetermined price. The automatic process means quicker transactions and, potentially, more profitable trading efforts–all buyers and sellers win. 

Finally, high-frequency trading virtually eliminates small bid-ask spreads. The stock market bid-ask spread is essentially the price difference between what someone is asking for and what someone else is willing to pay. Less of a gap between demand and supply could also increase how easy it is to buy and sell stocks in large volumes.

High-Frequency Trading Cons: Less Human Interaction, Volatility

One of the primary arguments against high-frequency trading is its lack of human interaction or intuition as broker-dealers step aside. This trading model relies on computer algorithms, but since these incredibly fast purchases and automated decisions don’t have any emotion or restraint behind them, expecting market volatility seems reasonable. 

The algorithm just trades based purely on the numbers rising and falling–it has no gut reactions. One infamous example is the Dow Jones Industrial Average situation in May 2010. When the automation didn’t stop, the DJIA experienced a 1,000-point drop (about 10%) in only 20 minutes, which was (and may still be) the largest intraday point drop in the DJIA’s history.

Some investors believe high-frequency trading offers larger institutions, like banks or hedge funds, an unfair advantage. Large companies have the means to carry out high-frequency trading strategies, which isn’t always the case for independent investors or smaller firms without powerful computers. The investigation into the staggering point drop for the DJIA revealed that a large order had started free-for-all selling with detrimental effects.

The Different Components of a High-Frequency Trading System

What is high-frequency trading going to look like? While the concept is relatively simple, a good high-frequency trading system utilizes several components.

A Database

High-frequency trading’s data is a whole world on its own. You can’t facilitate multiple order executions without a high-density database managing thousands of daily data inputs. 

A Scrapper

Your high-frequency database needs constant updates. The scrapper uses recently updated streamed data to keep your information brimming with the latest market information.

A Quantitative Model

If you want to avoid slippage–when expected and actual prices for an asset differ–your high-frequency trading system must include a quantitative model. Seeing market interactions can help you identify when there’s a lack of liquidity.

An Order Executer

Since high-frequency trading systems rely on fast and automatic transactions, you need an order executer. For this particular trading method, you’ll need a microsystem to execute positions and limit orders (it must only make purchases at certain price points). 

A Quantitative Analysis Tool

Lastly, quantitative analysis can prove incredibly helpful for traders. Do you find it easier to understand raw numbers via graphs like histograms? Various platforms like Streamlit offer similar visual representations so that you can easily assess any quantitative data at scale.

Take Your Trading Skills to the Next Level With Black Eagle Financial Group

What is high-frequency trading, and how can you take advantage of this algorithmic trading? Whether you’re interested in setting up high-frequency trading or want to explore other methods, Black Eagle Financing Group’s financial services company, prop trading firm, and hedge fund can help.We can answer your questions, outline your mentorship program options, and discuss our simple pricing structure for unique services like Nightvision! Contact Black Eagle Financial Group today at 833-253-2453.

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