Unravelling high frequency trading – what is it and how does work?

3 mins

In the last decade, algorithmic trading (AT) and high-frequency trading ...

In the last decade, algorithmic trading (AT) and high-frequency trading (HFT) have come to dominate the trading world. Between 2009-2010, more than 60 per cent of U.S. trading was attributed to HFT. Today, that figure is around 50 per cent for the US and marginally less in Europe (43 per cent).

HFT is a subset of algorithmic trading – a system where algorithms essentially work as middlemen between buyers and sellers. It allows traders to capitalise on tiny price discrepancies that can't be detected by the human eye and might exist only for a minuscule period.

How does it work?

Computer-assisted rule-based AT uses dedicated programs that make automated trading decisions to place orders. These algorithms can read real-time high-speed data feeds, detect trading signals, identify appropriate price levels and then place trade orders once they pinpoint a suitable opportunity. They can even place trades based on trend following, news events, and speculation.

The benefits of this approach are almost limitless. Not only does AT offer increased efficiency, accuracy and ultimately profitability, it is also able to consider and protect against any potential knock-on effects. For example, when large orders are made by insurance companies this can severely damage stock price levels. AT works to reduce that impact by breaking larger orders into several smaller ones, therefore offering traders some price advantage.

HFT is an extension of AT. It manages these smaller trade orders to be sent to the market at high speeds, often in milliseconds. This allows the algorithm to exploit fleeting market conditions by harnessing profit potential in an ultra-short time period.

Where does the network part come in?

So, how does this relate to the networking field? Well, for these high performing systems to actually function, a network infrastructure able to sustain the extensive and continuous volumes of activity is required. In other words, solid foundations must first be built.

The types of businesses trading in the financial markets are under increasing pressure to strive for greater speed and efficiency from their systems and processes. Every second counts in this highly competitive and volatile industry. Therefore, network connectivity capabilities are crucial.

HFT as an example, requires powerful computer programs and algorithms with the ability to carry out a large volume of transactions in fractions of a second. Those traders able to attain faster execution speeds can gain a competitive edge and have the opportunity to achieve greater profitability. Put simply, the faster algorithms can analyse stock exchanges and execute orders, the higher the profit will likely be.

As those in the sector look to invest in increasingly powerful networking solutions and advanced trading software, we’re likely to see a race between providers to offer superior solutions. And firms not able to keep pace with new developments such as HFT, will likely struggle to remain competitive and successful.

So, what are the key attributes needed to operate HFT?

Development in this area has yet to stay stagnant and there will likely always be a steady stream of transformations and adaptations that are able to skim seconds off current records. That said, when it comes to operating a high-frequency trading approach, there are a few tried and tested practices for firms to strive to maintain:

  • High-speed servers.
  • Real-time data feeds.
  • Advance algorithms that can rapidly analyse market data.
  • Low latency network connectivity.
  • Colocation – placing HFT servers closer to the exchange servers.

To achieve the optimum conditions for HFT, companies require expert talent able build exceptional systems and consistently look for opportunities to push boundaries that will drive the industry forward.

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