High-frequency trading is an advanced strategy that allows you to take advantage of small price changes. It became popular with stock traders but is now widely used on the crypto market. So, if you are interested in understanding this concept and applying it to your trading practice, this article is exactly what you need.
What is high-frequency trading?
High-frequency trading (HFT) is a system or approach based on algorithmic trading using powerful computers and specialized equipment. It includes high-speed execution of a large number of transactions and focuses on very short time frames.
As the name suggests, HFT is related to speed. This method uses various algorithms to analyze minimal price changes and divergences across multiple exchanges between the same asset prices. Typically, HFT platforms can automatically open and close multiple positions per second.
Several companies provide HFT platforms for investors who want to capitalize on the high volatility of cryptocurrencies. Traditionally, this method is used in currency, stock, and other markets. However, over time, high-frequency trading has gained momentum in the crypto space, mainly due to conducting multiple transactions per second, which provides many advantages.
Key aspects of high-frequency trading
The US Securities and Exchange Commission outlined the critical aspects of high-frequency trading:
• High-speed and complex programs should be used for generating and executing orders;
• The use of collocation services offered by exchanges and other service providers to reduce potential delays in data transmission;
• Very short time frames are used to open and liquidate positions;
• Submitting multiple orders that are canceled shortly;
• Reducing the risk of overnight.
In general, HFT is an integral and important part of all markets. High-frequency trading strategies are often dependent on the algorithms and hardware available to the trader. Unfortunately, institutional investors usually have better access to these tools than individual investors.
How does high-frequency trading work?
The speed at which transactions are processed requires a great deal of automation. But that doesn’t mean everyone can use this method. The computers used for high-frequency trading must be programmed to host complex algorithms that continuously analyze all cryptocurrencies across multiple exchanges with millisecond precision.
Trading experts create algorithms to detect trends and triggers that other traders cannot see. The program automatically opens many positions at high speed to be the first to profit from trends discovered by the algorithm.
When a whale enters a long or short position in a certain cryptocurrency, the price usually moves in line with that trade. High-frequency traders use algorithms to track such price movements and trade on the opposite side. For example, a large sale of cryptocurrencies can lead to lower prices. The algorithms will “buy the dip” and exit positions when the cryptocurrency returns to normal. Please note that we are not discussing significant price movements but rather short-term anomalies caused by large traders.
HFT can be applied in cryptocurrency trading, just like in traditional markets. However, in crypto trading, the risks and opportunities are higher due to the volatility of the space.
The main types of high-frequency trading
- Arbitrage trading
Crypto arbitrage is the process of speculating on the price difference of the same cryptocurrency on several exchanges. For example, 1 BTC costs $42,166 on the PointPay exchange and $42,186 on Binance at the same time. Traders who discover and exploit these differences are called arbitrageurs.
Although their main goal is to capitalize on market inefficiencies, they help balance the markets and balance prices. By using efficient HFT algorithms, traders are the first to exploit these price differences. In addition to detecting arbitrage opportunities, HFT platforms can open multiple positions and complete trades hundreds of times faster than any regular trader.
- Market making
Market making is another strategy used by institutional traders who speculate on the spread, placing “bid and ask” orders on the same market. Large companies usually offer this strategy, and it’s considered good practice. A cryptocurrency exchange may partner with one or more such companies to maintain high liquidity.
- Short-term trading
High-frequency trading is not intended for people who want to buy and hold crypto. Instead, it is used by people who want to speculate on short-term price movements. You can think of it as scalping. High-frequency traders use powerful computers and algorithms to provide profits within seconds or even milliseconds.
Let’s look at an example. A whale dumps a cryptocurrency; its price is likely to decline for a very short period before the market corrects it to balance supply and demand. While most regular traders can’t take advantage of this dip as it lasts only minutes or even seconds, it represents a great opportunity for high-frequency traders who have enough time to let their algorithms do the work.
- Volume trading
High-frequency trading allows many trades in a short time frame. By using automation, high-frequency traders can make a number of trades that would be too risky for ordinary traders. Such traders may benefit from the smallest market fluctuations.
Like any trading strategy, HFT has its advantages and limitations.
Benefits of high-frequency Trading
- Increasing profits through speed and automation
For traders, the main advantage of HFT is speed and automation. This is because the algorithms do not need human intervention to identify market opportunities and open hundreds of positions within minutes or seconds. In addition, the HFT trading platform can detect price trends earlier than anyone else.
- Providing liquidity to support markets
HFT is believed to benefit the entire market. For example, it reduces the bid and ask spreads and brings more liquidity.
- Eliminates potential bugs
High-frequency trading eliminates human error. This is because the trading system uses complex mathematical processes to analyze the markets and guide the trading process — no risk of bad decisions driven by fear or other emotions.
Limitations of high-frequency Trading
Despite all possibilities, HFT is controversial. And many jurisdictions are even considering banning it altogether due to potential market manipulation.
- High risk to reward ratio
The risk to reward ratio in HFT is very high compared to traditional trading methods. Each position of a high-frequency trader can bring only a few cents of profit. The idea is to provide a significant overall profit from multiple positions. However, the likelihood of significant losses can be enormous.
- Working with poor quality algorithms
Another significant risk is related to poor algorithms, such as fraud; the sole purpose is to receive a certain amount for a service that is not useful in practice.
- Probability of market manipulation
Despite the risks, HFT has been criticized for helping a privileged group of traders increase their profits at the expense of smaller players. Furthermore, critics suggest that high-frequency trading promotes market manipulation and unnecessary volatility. They also say that HFT trading can lead to flash crashes, which have occurred when the computerized trading system in one stock suddenly malfunctions, leading to rapid selling and buying of large volumes of that stock.
- Great opportunities for illegal activities
High-frequency trading algorithms can be designed to place thousands of orders and cancel them seconds after a short-term price increase is triggered. Some experts have argued that high-frequency trading only generates “phantom liquidity” as the few orders placed by such traders only last a few seconds or minutes and then are removed.
Conclusion
High-frequency trading is more suitable for institutional investors, as they know the market and know how to deal with unexpected changes. However, it has become technically accessible to everyone as there are advanced algorithms that anyone can access for a price. It is best to stick to regular trading to gain experience and learn to understand the market. To start, try day trading and then hone your skills to move towards HFT over time.
