HFT – High Frequency Trading – is a relatively new addition to the forex landscape, one that hasn’t arrived without controversy. Requiring dedicated servers, top-of-the-range connectivity and fast execution to make trades in milliseconds, HFT is usually thought of as the preserve of a few giant institutional players.
In fact it is possible, although very difficult, to use HFT strategies as a retail trader. What is of more concern to the majority of retail traders is the much-discussed possibility that HFT traders are somehow adversely impacting the same markets retail traders use, frontrunning their trades and causing worse price discovery. At least in the forex market, these concerns are likely misplaced, although traders would do well to be aware of their potential for disruption.
Several phenomena have been blamed on HFT, alongside some claims they improve overall spreads for retail traders by providing liquidity. Among the most significant are flash crashes, front running and ‘spoofing’, or the placing of ghost trades that are immediately cancelled. This has contributed to a perception markets are rigged against small players, but in reality the targets of such practices are almost always other major institutions. Retail forex players, with some exceptions, are able to fly under the radar of HFT firms and benefit from improves spreads without the risks.
What is high frequency trading?
As the name suggests, HFT relies on fast execution to profit of tiny discrepancies in market prices. For example, an arbitrage may exist between the bid-ask spread of one bank and another. If this difference is extremely small, or exists only for a few seconds, traditional arbitrage traders will not be able to benefit from it and it will not be traded away.
Using automated programs, HFT allows traders to arbitrage even these fleeting, small opportunities. This is good news for traders in general, as it results in lower spreads. The Canadian regulator carried out an experiment with introducing fees on HFT (making this strategy unprofitable), and significant increases in both retail and institutional spreads followed.
Other HFT strategies also exist, for example algorithmic news-based strategies. These strategies involve using AI to gauge sentiment from thousands of news sources instantaneously, and issuing a buy or sell signal based on news events before manual traders have a chance to react. The take profit levels on these trades will be very small, and they are able to produce profit because of specially negotiated fees and the sheer volume traded.
Problems with HFT
HFT practitioners justify their position – which essentially amounts to an information advantage over other traders – by claiming it improves liquidity for all participants. One issue with this is the liquidity is often fleeting; positions are opened and closed within a second, minimising the possibility for any other traders to actually place orders at the prices listed. This has fuelled scepticism about the practice more generally.
Certain examples of market malpractice are also easier with HFT. Frontrunning is a legal practice where a HFT sees that a major institutional player is making a large order, so they quickly trade in the same direction knowing that the price will be pushed in the direction of the institutional trade. This can have the effect of eating into the profits of the institutional trader.
Frontrunning is legal, but the related practice of ‘ghost trades’, where a HFT firm sees a large incoming trade, then places a similarly large one that shifts the market price, before immediately cancelling it. This has a clear adverse effect on other participants, and is dishonest. This strategy was accused of causing the 20 minute 10% ‘flash crash’ in the Dow Jones in 2010.
Flash crashes, though mercifully rare, are a real danger to retail FX traders. No matter how well-reasoned your trade, how carefully your risk management, if your market suddenly tanks by 10% with no warning before recovering you will be stopped out. Market regulators are extremely interested in this phenomenon for exactly that reason, and should these events become more frequent we can expect to see quick regulation of HFT firms. For now, the event seems a one-off, although some analysts believe HFT may contribute to overall market instability.
HFT and the retail market
All this seems quite distant from the concerns of retail traders, but HFT impacts normal retail business in several ways. Firstly, the improved spreads are offered to all market participants, driving down a significant cost for retail forex traders. Increases in liquidity are less important to the forex market, where it has always been high, but for traders in other markets HFT provides some clear benefits.
Most attention to HFT has focused on its ability to trade against other participants. Large, slow institutions like pension funds have paid particular interest to this possibility, as it has the potential to severely impact their returns. For retail traders these concerns are greatly reduced, as no retail order is likely to be large enough to bother front running.
Some retail traders rely on arbitrage strategies to make their profits, though this is rarer in forex than other markets like commodities. Sometimes possible with exotic currencies, arbitrage involves buying and selling simultaneously in different markets where prices are unequal. Given arbitrage opportunities disappear when they are traded, any market with HFT arbitrage strategies will be hostile to retail traders using the same strategies.
Doing HFT on your own
Contentious but possible, some retail traders use hired space on servers to implement their own HFT strategies. This requires a good level of programming ability, a broker willing to rent out server space in addition to connectivity to one of the standard trade execution platforms.
Arbitrage strategies are likely off-limits to such traders as their spreads will not be competitive compared to dedicated firms, they will not have large institutional lines of credit, and even the best rented server space will not compete with dedicated proprietary hardware. However, news sentiment trading or other algorithmic strategies are probably replicable by very sophisticated and technically-skilled investors.
Just because something is possible doesn’t mean it’s a good idea, and the likelihood of making significant profits with this strategy is slim. Instead, retail investors would do well to understand the impact of HFT on the markets they work in, avoid clearly impossible strategies such as arbitrage, and benefit from any reduction in spreads.
HFT is a relatively new, but well-established part of the financial markets landscape. Even traders with no interest in such strategies can benefit from being aware of the different ways they can be affected. For those retail traders working on highly quantitative strategies, it may be of interest that they can in some cases use similar strategies with hired servers. It should be stressed any retail players dipping into this market are greatly disadvantaged compared to vast institutional firms.
For the majority of traders, understanding HFT instead forms part of their general markets awareness. Knowing who places what orders in the market and why is a huge advantage to traders, as it allows you to better predict market direction. For example, a retail trader using a manual news-based strategy should be aware that HFT firms are likely to make tightly profit-levelled, rapid trades in the immediate aftermath of any announcement. Equally important is understanding they will see this information and enter the trade before you can. Knowing this allows the retail news trader to take a slower strategy, aiming to benefit off reaction or overreaction rather than guessing the news.
Knowing where not to trade is as important as knowing where you should. It is best to avoid markets where you have an information disadvantage. Retail traders are already disadvantaged by their small account sizes and unfavourable rates, so successful strategies rely on not piling on more negatives. Knowing about HFT is one way to do this.
How Rakuten can help
HFT is an important part of the markets landscape. For retail traders, HFT probably presents more of a risk than an opportunity, but being well-informed can only help you to make good decisions. If you want to test your new knowledge, why not open a free demo account and start trading today without risking any of your capital?