What is High-Frequency Trading (HFT)? [Full Explained]

What Is High-Frequency Trading?

High-frequency trading  is a type of trading algorithm that is conducted by high-speed computers. The algorithm analyzes market data and finds the trading opportunities in microseconds or even nanoseconds. HFTs can execute many trades very fast, helping traders increase small profits faster through high volume, which can add up to substantial gains.

High-frequency trading example:

Nasdaq uses two types of HFT systems: execution trading, which is done by an algorithm designed to achieve higher profits, and trading opportunity searching.

How Does High-Frequency Trading Work?

A single millisecond delay can mean the difference between making and losing money; this is why HFT systems are engineered to be extremely fast. The HFT system is faster than 400 milliseconds, and sometimes even microseconds. Here’s how it works

1. The first HFT system will receive the market data directly from the market exchanges.

2. Then store data in the live order book in the system's market.

3. The system, like an FPGA, is making a decision to find a trading opportunity.

4. The smart order router is placing the order.

5. Then, execution systems will be monitored.

6. HFT will exit the trade by looking for an inefficient market, such as:

   • Price differences between exchanges.

   • Temporary imbalances in the order book.

   • Slow price updates.

Why Do Traders Need to Know High-Frequency Trading?

Traders need to understand high-frequency trading because it shows that price movements don't always reflect market supply and demand. Since HFT is used by institutions, banks, and brokers, it helps you spot when the big players enter the market and wait until you see the liquidity. This increases the opportunities for traders to profit from short-term price movements.

Why are spreads and liquidity important for HFT?

Spreads are always associated with liquidity. Some markets with high activity offer narrower spreads, while those with low trading volume offer wider spreads. In HFT, the right spread is essential to generate profits from small price changes. But in a low-liquidity market, HFT might reduce activity to avoid slippage.

What are High-Frequency Trading Strategies?

Understanding High-Frequency Trading (HFT) helps you identify the best trading opportunities. It is typically used by large institutions, enabling traders to increase profits quickly through high volume. Here are the top 3 most used strategies in HFT trading, according to Fxpro and Propfirmplus.

Strategy 1

“Market Making” is when institutions, banks, or trading firms enter buy or sell orders to provide liquidity.

For example:

• In an HFT trading strategy, a trader will bid stock at $10 and keep the ask at $10.20.

• When both bid and ask orders are filled, the profit will be $0.20.

Real-life example:

• Virtu Financial is a global market maker, providing liquidity across thousands of stocks, ETFs, and currencies daily, earning millions by capturing tiny spreads.

• Citadel Securities executes a significant portion of U.S. equity and options trades, using HFT to profit from bid-ask spreads.

Strategy 2

“Statistical Arbitrage” is a trading strategy in which you make money when an asset is overpriced relative to its expected future value.

The algorithms monitor to ensure that the stock and other financial instruments move together. If the price moves differently, it indicates trading opportunities.

For example:

In this example, we will test two stocks that usually move together, like Tesla (TSLA) and Google (GOOGL).

If Tesla (TSLA) is undervalued than it should be, and Google (GOOGL) is overpriced than it should be, you can:

• Buy Tesla (TSLA) if expecting the price to go up

• Sell Google (GOOGL) if expecting the price to go down

Real-life example:

• Two Sigma and Renaissance Technologies use statistical arbitrage to trade hundreds of stock pairs and ETFs, generating consistent profit.

• ETFs often have slight deviations from their underlying assets, allowing HFT systems to buy the cheaper asset and sell the more expensive one quickly.

• Some hedge funds apply this strategy in commodity markets, e.g., gold and silver, to exploit small pricing differences between futures and spot prices.

Strategy 3

“Tick Trading” is a small change from one trade to the next.

Let's assume A is a liquidity provider.

Every time you try to improve the bid-ask price, someone is going to be ahead of you by one tick.  For example, A wants to buy at $100, the HFT will place a bid at $100.20. 

For example:

• If Apple (AAPL) has a tick size of $0.01

• The last price traded was $10

• Best bid is $20

• Best ask is $20.20

  • HFT will place a bid order at $20.01, just one tick above the best bid.

  • HFT will place a sell order at $20.18, just one tick below the best ask.

Once the HFT's order is the best ask price, it will be filled automatically, and the HFT will earn the profit.

Real-life example:

• KCG Holdings (now part of Virtu) used tick trading to scalp spreads across equities and futures.

• Currency pairs like EUR/USD or USD/JPY are frequently traded with tick strategies to capture micro pip movements repeatedly.

Strategy 4

"Latency Arbitrage" is a trading strategy that helps you take advantage of the tiny delays, whether milliseconds or even microseconds.

For example:

Let's assume you want to trade Apple (AAPL)

Broker A has a 3-millisecond delay, while Broker B has already placed a buy.

HFT will detect the price on Broker B first, so the algorithm will be:

• Buy 100 shares on Broker A at $100

• Buy 100 shares on Broker B at $100.03

When Broker A updates the price, the trading opportunity will disappear.

Real-life example:

• During the 2010 Flash Crash, latency arbitrage contributed to rapid market swings.

• Jump Trading uses servers co-located near exchanges to gain microsecond advantages over competitors.

• Forex markets exploit differences in ECN feeds across platforms like EBS and Currenex to create temporary price gaps.

Pros and Cons of High-Frequency Trading

High frequency trading (HFT) can have advantages and disadvantages for traders that you should consider:

Conclusion

High-frequency trading is an algorithmic approach that automates trading systems in finance. It helps traders profit from small moves with high volume.

There are many different strategies that will increase your understanding of how to apply them in the real markets.

There are always pros and cons that traders should consider before using the strategies. Overall, understanding HFT is crucial to know how the market moves in detail.