High frequency trading, popularly known as HFT is a new buzz in the town for the people associated with financial markets. It has been gaining popularity exponentially through the last decade. People have a common misconception that HFT is only for large hedge funds or mathematical geniuses. But, that’s not completely true, even retail traders can participate in HFT provided they have necessary resources and knowledge to do so. This post intends to introduce HFT to retail traders and explain some of the High frequency trading strategies. Since HFT is based on Algorithmic trading, I would recommend to go through the below introductory article first:
What is High Frequency Trading?
High frequency trading is a computational trading system that uses powerful super computers to place buy/sell orders in fraction of seconds. These super computers analyze gigabytes of data across various sectors and timeframe to arrive at the best possible trading decision. A pre-defined trading algorithm(s) needs to be fed into these computers before making it live. Some HFT systems also have artificial intelligence capabilities to learn and optimize the trading algorithms. Speed is a key factor for the success of HFT systems. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2012, it is estimated more than 50% of exchange volume comes from high-frequency trading orders. The next section will describe some of the most popular High frequency trading strategies.
High Frequency Trading Strategies
Although there are no pre-defined rules to select strategies for HFT, but there are few popular strategies which are more popular than others and used by most of the HFT trading firms. Below High frequency trading strategies are complied from various sources:
- Statistical Arbitrage: This strategy exploits the temporary deviations of various statistical parameters among various securities. Statistical arbitrage at high frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Even classical Arbitrage can be used by examining the price parity of securities in different exchanges or spot and future market. The TABB Group estimates that annual aggregate profits of high-frequency arbitrage strategies exceeded US$21 billion in 2009.
- Option pricing disparity: Generally, it takes some time for the price of an option to follow a stock and vice versa. Modern HFT systems are capable to precisely model these differences to arrive at a favorable trade. Read about options pricing and Black-Scholes model to understand this better.
- News based HFT systems: Company news in electronic text format is available from many sources including commercial providers like Bloomberg, public news websites, and Twitter feeds. Automated systems can identify company names, keywords and sometimes semantics to trade news before human traders can process it.
- Momentum Ignition: This strategy aims to cause a spike in the price of a stock by using a series of trades with the motive of attracting other algorithm traders to also trade that stock. The instigator of the whole process knows that after the somewhat “artificially created” rapid price movement, the price reverts to normal and thus the trader profits by taking a position early on and eventually trading out before it fizzles out.
Pair Trading: Pair Trading is a market neutral strategy where two highly co-related instruments are bought and sold together when there is a certain degree of deviation in their co-relation. Usually the stock or commodities selected for Pair Trading are from the same sector and moves together during most of the market events. Pair trading in intraday timeframe through HFT systems have given impressive results. Read more about pair trading here.
Apart from the above strategies, you can adapt any intraday strategy for HFT. But you need to be very careful about risk management and execution speed. Usually HFT trading firms co-locate their servers near the exchange to gain advantage over others in terms of speed. Check out our articles and systems on Intraday trading at the below link:
Also, here are the tools you need to automate your intraday trading strategies.
HFT, Algo Trading and Automated Trading
These 3 terms are mostly used in the similar context, but they are not actually same. Automated Trading is the subset of Algorithmic Trading, while HFT is the subset of Automated trading. The below image explains it in a better way:
Benefits and Risks
The major benefit of High frequency trading is the improved market liquidity it generates. Bid-Ask spreads have reduced considerably since the inception of HFT. Also, it has opened up enormous opportunities in financial markets mainly in Algorithmic trading firms and mathematical modelling. However there are lots of controversies associated too. HFT has replaced a large amount of broker-dealers and uses mathematical models and algorithms to make decisions, taking human decision and interaction out of the equation. Decisions happen in milliseconds, and this could result in big market moves without reason. As an example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) suffered its largest intraday point drop ever, declining 1,000 points and dropping 10% in just 20 minutes before rising again. A government investigation blamed a massive automated order that triggered a sell-off for the crash. This event is called Flash crash.