What is high-frequency trading?

Definitions differ, but at its most basic, high-frequency trading implies speed: Using supercomputers, firms make trades in a matter of microseconds, or one-millionth of a second. Goals vary. Some trading firms try to catch fleeting moves in everything from stocks to currencies to commodities. They hunt for "signals," such as the movement of interest rates, that indicate which way parts of the market may move in short periods. Some try to find ways to take advantage of subtle quirks in the infrastructure of trading.

Other firms are "market makers," providing securities on each side of a buy and sell order. Some firms trade on signals and make markets.

How do players make money in high-frequency trades?

Many high-frequency traders collect tiny gains, often measured in pennies, on short-term market gyrations. They hunt for temporary "inefficiencies" in the market and trade in ways that can make them money before the brief distortions go away. Market-making, high-frequency firms hope to make money on the difference between how much investors are willing to buy and sell a stock, or the "bid-ask spread." They do this by selling and buying on both sides of the trade. Many exchanges offer "rebates" of about one-third of a penny a share to outfits that are willing to step up and provide shares when needed.

What are "flash orders"?

Typically on trades, exchanges pay rebates to traders who post shares to buy or sell and charge fees to traders who respond to those offers. This setup creates an incentive to earn rebates. That is one place where flash orders come in. With a flash order, a trading firm can keep its order on a certain exchange for up to half a second without matching an existing buy or sell order on another exchange, a move that puts it in a position of poster, rather than responder. The hope is that another trader who needs to buy or sell quickly steps in on the other side of the trade. This dynamic boosts the chance the flash-order trader will complete the trade on the exchange and get the rebate. Exchanges offer flash orders to keep market share.

Components of a HFT strategies

High-frequency trading is characterized by a high turnover of capital. The positions have very short holding times in computer-driven responses to market situations. Typically high frequency trading applies to multiple trades each day, gaining small returns per trade, with very limited, if any, positions carried overnight. Overnight positions are not considered for high speed trading because with the current volatility in the markets, which extend most of the trading activity over the to 24-hour, they are particularly risky. Moreover, overnight positions taken out on margin have to be paid for at the interest rate referred to as an overnight carry rate decreasing the profitability of of this type of operations.

Low Latency

High-frequency trading strategies are highly dependent on ultra-low latency.To realize any real benefit from implementing these strategies, a firm must have a real-time, colocated, high-frequency trading platform where data is collected, and orders are created, routed and executed in sub-millisecond times.

Multiple asset classes and exchanges

Since many high-frequency trading strategies require transactions in more than one asset class and across multiple exchanges, appropriate infrastructure is required to facilitate long-haul connectivity between different data centers.

Limited Shelf Live

The competitive advantage of a high-frequency trading strategy dilutes over time. Although a firm's high-level trading strategy may remain consistent over time, its micro-level strategies are constantly altered for two important reasons. Firstly, because high-frequency trading depends on extremely precise market interactions and security correlations, traders need to regularly adjust code to reflect subtle changes in the dynamic market.Secondly, competitive intelligence is so good across rival trading firms that each is exposed to the increasing susceptibility of their strategies being reverse-engineered, turning their most profitable ideas into their most risky.

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