With programmable expert advisers available on nearly every serious trading platform, it’s simply a matter of time until systems are up to speed that will enable high frequency trading. Until then, we have some time to examine just what that is.
What is High Frequency Trading?
High frequency trading is a form of trading that only became possible after the Securities & Exchange Committee authorized the first electronic exchange in 1998. Within the span of a decade, ‘high frequency’ was being measured in microseconds (that’s a millionth of a second), and apart from actually programing the unbelievably complex algorithms (algobots, from ‘algorithm’ + ‘robots’), the human element became almost irrelevant. In 2013, high frequency trading Accounted for 35% of spot forex trades alone.
In very rough terms, high frequency trading entails holding assets for very (and I mean VERY… see above) short periods and taking advantage of those really short periods from the moment an event actually takes place and the moment at which the market reacts. Whoever has the faster system is the one who makes the killing. The fluctuations are small, so small that even with leverage you wouldn’t be making much. What that means is that to succeed, the investor needs to have huge amounts of capital – enough to purchase that very fast computer and ultra-fast modem. But before that, you’ll need to know what’s about to happen. Once again, human eye is not swift enough to scan the market and seek the opportunity; so here too, it’s the computer that does the work – we’re talking of databases several times larger than NASA’s.
A possible scenario might be a trader (we’ll call him Tod) who places an order but finds that it can’t be fulfilled at the quoted price, quite simply because his order has been identified by a computer (Hal, for the sake of clarity) far away, which then proceeds to place a counter offer before the original order has made its way from Tod’s computer to the exchange. To top it off, Hal’s people then offer the asset to Tod and his potential followers for a price that’s not too much higher, but enough for them to make a killing.
How does High Frequency Trading Differ from Traditional Trading?
Much to the consternation of traditional traders, though, high frequency traders have been shifting their focus from following the market to actually manipulating it. Imagine, if you will, a situation in which a huge order creates a small fluctuation; the person who placed the order then places a huger order that profits from that fluctuation, then closes the two – and all of that quicker than the flicker of an eye. The trader has quite simply removed an impressive amount of market liquidity in an undetectable manner – conversely, but not unlike Dash Parr placing the pin on his teacher’s chair.
The Flash Crash of 2010 occurred in this manner: A mutual fund sold several billions of dollars in futures contracts as a hedge. High frequency traders immediately reacted and amplified the reaction, driving futures down by 3% in 4 minutes and pulling equities down with them. The market’s computerized systems then took over, identifying a problem, and shut down.
The situation becomes ridiculous, though, when one algorithm driven trading robot ends up trading against another. In this situation, no actual trades end up being made; but the fake quotes (‘spoofing’) do end up draining liquidity and increasing volatility.
Although high frequency proponents claim that this high frequency trading actually eases volatility and poses no actual risk, it has by now been recognized by most researchers, regulators and traders that the dangers posed by high frequency trading has resulted in wider spreads, reduced liquidity and threatened market stability.
The Future of High Frequency Trading
Dr. Micho Kaku, an American futurist and theoretical physicist at New York City College, believes that Moore’s Law is finally breaking down, and that the number of computers on a chip is no longer doubling every 2 years. Notwithstanding, it is relatively clear that the computer power at the service of high frequency traders might soon be within the reach of home-based retail traders like you and me; and that as soon as I figure out how to program those expert advisers, which will be available on some future version of MetaTrader, to do what their algorithms do, I just may begin experimenting… even if it does take away the excitement.
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