High-frequency Trading Signals: Definition and their Advantages and Disadvantages
HFT started in 2000 and has grown since the beginning.
In the previous article about forex trading signals, we gave examples of both manual and automated trading signals. In the automated forex signals article, we mentioned high-frequency trading (HFT) signals. When you get alerts or the computer conducts the trade, it counts as a trading signal service. Thus, HFT trading is ranked in the trading signals category. It is a computerized way of trading based on algorithms. These detect small movements that humans cannot and try to catch a minimal amount of pips in a large volume. Then it repeats the process, thousands of times in a trading session.
Automated trading had its beginning of the ‘80s when the modern computers became common in the finance industry. Yet it took another 15 years until the financial world started using high-frequency trading. The US financial authorities authorized the electronic exchanges in 1998 and the first trade started in 1999. Since then HFT has been ascending it accounts for about 10% of orders in the equity market in the early 2000s. But in the peak of 2009, HFT transactions made up 73% of the total orders in the US. At the moment, HFT orders make up about 38% to 40% of European order and 56% in the US. The profits have declined since 2009 and at that time, the HFT firms were making about 5 billion dollars of profit altogether. Their worth was around $1.25 billion in 2012.
One of the main reasons that the financial authorities allowed HFT is the liquidity. The HFT firms placed millions of trades a day, meaning that there was always a counterparty willing to buy whatever you wanted to sell and vice versa. Most of the exchanges offered rebates and other incentives for these liquidity providers. For example, the New York Stock Exchange offers $0.0015% per trade, which might seem a small amount at first.
An HFT firm caused the 2010 flash crash in the Nasdaq and the NYSE.
Their high-frequency trading signals have always been questionable to some degree. Some complain about increased volatility when the HFT firms withdraw from the market, such as the 2010 Flash Crash. Others argue that firms or traders that use this trading method scrape profits from real investors. Although the HFT is well-regulated now, there have been many requests that the exchange authorities curtail the HFT. Italy for example, charges a 0.02% tax for trades that last less than half a second. So like with any other technological advancement, high-frequency trading offers advantages and disadvantages to any firms using their method.
Pros of High-Frequency Trading
- Direct access – The HFT firms are exchange participants that have direct exchange to the market, and thus skipping the broker fees.
- Two-way rebates – The HFT firms receive a rebate fee for every execution. They receive two rebates for the same order: one for buying an instrument and another for selling it back.
- Endless opportunities – Even when the markets are quiet there are opportunities for HFT signals. This is because they only aim for a 1-2 pip profit or less.
- Limited risk – Since this system places small take profit targets, the stop loss targets are small as well. This way, even if you get caught on the wrong side of the market the damage to your account is limited.
- Unfrozen funds – The traders or institutions that use the traditional trading strategies usually open many orders on different forex pairs and keep them for whatever time they find reasonable. So the funds that are used in the open positions remain frozen until the trades are closed. HFT eliminates this because the trades are closed almost immediately. At the end of the day, the HFT firms have no open orders so they do not accumulate positions.
- Increased liquidity – One of the most important reasons that HFT was introduced was due to increased liquidity. HFT accounts for about half the orders and liquidity in many of the biggest trading floors.
- Narrow spreads – HFT firms compete with brokerages and other firms and institutions that take part in the exchanges. Thus, they contribute a lot in lowering the buy/sell spreads.
Cons of High-Frequency Trading
- Small take profit targets – The take profit targets that this strategy aims at are usually less than a pip. It´s true that HFT systems execute thousands and millions of trades a day, but the trades that account for most of the profit at the end of the month are the ones that you let run for hundreds of pips.
- High risk/reward ratio – Since the profit targets are small, the risk/reward ratio is very small too, 1:1 at best, while this ratio is 1:3 up to 1:10 for the traditional traders.
- Liquidity holes – HFT firms play a big part in the liquidity of the financial markets, but during certain events they can withdraw from the markets fast, thus leaving a liquidity hole. The 2010 flash crash was a prime example of this, when the HFT firms withdrew their funds sending the market crashing down.
- Not for the ordinary trader – HFT firms usually have direct access to the market, so the normal traders that place their orders through brokers can´t always use HFT signals. You can buy HFT software, but the broker spreads make it almost impossible to trade this way.
- Frontrunning – Frontrunning happens when a HFT detects an order for a forex pair from a client and buys it a fraction of second before you do. They then sell it back to you at a higher price. It is illegal but it´s a reality.
HFT offers about 50% of the liquidity in the financial markets nowadays.
After almost 15 years of presence in the financial markets, the HFT has become an important part of the financial industry. There still are some loopholes that can be useful to unscrupulous individuals. Yet, the regulation is catching up and tightening the rope. One of the primary examples is the 2010 flash crash when the stock market was manipulated by a single-person firm based in London. The manager is facing trial in the US now and the chances are that he´ll go behind bars. Frontrunning, spoofing, and layering are considered illegal now. Anyway, the advantages are ranked higher than the disadvantages so the HFT is here to stay.