how high frequency trading works

If you want to learn how high-frequency trading works, you have landed in the right place. The high-frequency trading algorithm now accounts for between 50% and 70% of all trades that happen in the market. These trades are not executed by a human being or as a result of a human decision. They’re actually executed by an algorithm at a speed rate and scale that’s beyond our comprehension.

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Nowadays, trading has become inhumanly fast. In the HFT world, we only deal in microseconds. High-frequency traders might do thousands of trades in a minute. However, most of these trades are only the computers testing the markets.

They simply fire up a bunch of buy and sell orders and when another computer algorithm bites on one they’ll quickly cancel the ones that didn’t stick. All of this happens on a microsecond basis.

Some high-frequency trading algorithm has the sole purpose to combat other HFT algos and take them out.

Back in the day when the humans still ran the trading pits the average time that it took to execute a trade was around 11 – 12 seconds. The basic law of the market is that the fastest will usually win. There is always a benefit to getting information faster than the other market participant.

high frequency trading

Let’s say the NFP report is due next! If the jobs numbers are strong it can help the stock market to push higher. If you can get the numbers in advance and rush to the market before anyone else gets there and buy the stock before it goes up you can make lots of money.

Nowadays with the electronic trading the law of the market works the same but on another level of speed!

Moving forward, you’ll learn how high frequency trading works and how you can front run the high frequency trading strategies and get in before the algo runs the markets.

How High Frequency Trading Works

high frequency trading algorithm

What is high-frequency trading?

Essentially, high-frequency trading or HFT is fast trading through the use of very powerful computers. The high-frequency trading algorithm has an inconsiderable advantage in the market because it allows them to trade extremely quickly.

In order to understand how high-frequency trading works, you need to understand the terminology used by HFT traders:

  • Collocation
  • Algorithms
  • Program Trades
  • Automated Market Makers (AMM)
  • Flash orders
  • Front Running

Collocation is when these HFT companies put their servers as close to the servers of the exchange they’re trading on. Collocation is crucial because it makes the transactions move really quickly.

If there is a very little distance for the orders to travel it speeds up the transactions.

Let’s take as an example with an institutional trader that wants to buy 1,000 shares of GE which are trading at $10.50. He doesn’t want to pay more than $11 for the GE shares. So he has a $0.50 range to play with. However, he can’t go straight into the market and show up his hands because other investors, particularly the HFT traders can see and manipulate the price of GE stock.

high frequency trading algorithm

Our institutional trader can create an algorithm or computer program to break his orders into little bits. For example, he can choose to break his big order into 10 blocks of 100 shares each. Also he will instruct his algorithm to not buy higher than $11 a share.

high frequency trading

The high-frequency trading algorithm is also out there and it can detect what is going on in the market. They can see these blocks of 100 shares coming in the market and realize that some investors are buying in bulks.

These HFT algos then deploy their automatic market makers into action and it starts to send offers into the market.

The way the high-frequency trading strategies works is something like this:

The HFT algo first starts and send an order of 100 shares at $13, but nothing comes back because the other algorithm is programmed not to buy higher than $11. The HFT algorithm immediately cancels that order.

The HFT algo tests the markets again and sends another order for 100 shares at $12, but nothing comes back and the order is immediately cancelled.

This all happens in a fraction of a second.

The HFT algo will keep testing the market until he hits the $11 mark. Then the offer is lifted and the automatic market makers algo immediately goes out and buys as many GE shares as he can and it comes back and sells them at $11 to the other institutional investor.

The reason why he is forced to sell at $11 is because there are no other shares left in the market at this point because the AMM has dragged all the available shares and therefore is able to manipulate the price and to force the price upwards.

There are various types of high-frequency trading algorithm build to take advantage of price movements in the market and also to juice the market.

Another weapon that these HFT programs can use are flash orders.

Whenever an order comes into exchange the stock exchange is required to send that order right to the wider market. Or, it can simply flash the order to the stock exchange members.

When an order comes into the stock exchange, if the exchange uses flash order, then just for a fraction of a second it flashes that trade or that order to all the investors’ members within the exchange. They have the split-second option to fill that trade or if not the order is then sent to the rest of the market.

HFT programs

This obviously gives the exchange members an advantage because they get to see the orders before anybody else and front run these trades.

Front running is simply knowing someone’s about to buy a some stock shares and then quickly buying up as much as possible to sell it back to them at a slightly higher rate than you bought it for.

·         Conclusion – High-Frequency Trading Algorithm

A lot of the hedge funds and investment banks have made a great deal of money from the high-frequency trading algorithm. We hope this high-frequency trading tutorial has made some light on how these complex programs have become to rule the markets. Even though the crypto is a relatively new market we can find high-frequency trading cryptocurrency algos even there.

High-frequency trading uses astronomical speeds because they are all competing with other HFT algorithms. This is a game of speed and whoever gets there first, gets the gold. Time will tell if the ultra-fast algorithmic trading will benefit us or hurt us.

But we have to keep in mind that really bad stuff can also happen as a result of the HFT algo actions which are to be blamed for the flash crash of May 2010 when in less than 1 hour the most important stock indices in the world lost 1,000 points.

Thank you for reading!

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