If you blink, you might miss it!! Human civilization has been obsessed with speed since the beginning of time. Technological advancements are continuously making daily operations better and, of course, faster.
We know that the FX market is a trillion-dollar industry. So some speed goes a long way to handle all this money, which is where forex high frequency trading (HFT) comes in. HFT has been around for a long time and is not exclusive to currencies.
Any traded market, whether it is crypto, options, or precious metals, benefits from high frequency execution. But here, we’ll look at HFT in forex, how it works, and whether it has a massive impact on retail traders.
What is high frequency forex trading?
Forex high frequency trading is the practice of using computer programs or algorithms to transact a massive amount of positions in microseconds.
Here, companies and investors can achieve a lot with a high frequency forex trading strategy that wouldn’t be possible ordinarily. HFT has its roots in the 90s through stock exchanges where companies saw incentives to add liquidity.
Any market needs liquidity to function seamlessly, which is a market maker’s job. High frequency trading allows forex market makers or liquidity providers to process far more orders in seconds. Among other things, these companies profit more from spreads and transaction costs.
However, high frequency trading forex can achieve more:
- Easier arbitrage opportunities
- Faster news or short-term trading
- Manipulative strategies like layering and spoofing
High frequency forex trading is generally reserved for large financial companies like hedge funds and investment banks, or firms specialising in HFT.
The main reason is that high frequency trading software and infrastructure costs too much of an arm and a leg for the average trader.
Common high frequency forex trading strategies
Here, we’ll look at the simplest avenues where HFT is used in forex.
This is the easiest to understand of all the high-frequency forex trading strategy types. Arbitrage in forex is when you capitalise on tiny price differences from identical markets offered by two separate brokers.
The most basic form of arbitrage is buying a forex pair at a lower value from one broker and quickly selling it for a higher value at another. We refer to this as two-currency arbitrage. However, we have other complex types like triangular, interest rate, spot future and statistical arbitrage.
Forex high frequency trading is capable of all kinds. Opportunities for arbitrage are limited and short-lived, lasting for a few seconds. Yet, advanced software can scan multiple markets and patterns from different trading venues connected simultaneously. When a set-up arises, it can execute for a quick profit.
Let’s demonstrate an example of two-currency arbitrage.
Assume that the exchange for GBP/USD was 1.11400 with one broker and 1.11450 with another. Let’s also imagine you had $1 million. Here, high frequency forex algorithms can buy the pair, receiving £897 666.
Afterwards, they can sell the same pounds with the other broker at 1.11450, resulting in $1 000 448, a $448 profit from the initial investment.
Trading the news is an attractive way to increase your equity in the markets. Scalpers and day traders have to be very quick to react to high-impact economic announcements. However, forex high frequency trading can trade even faster.
Speed is one of several crucial factors when trading the news. Algorithms are better at predicting the likely outcome of a news event by looking at past historical trends and scanning multiple sources like Bloomberg and Twitter.
News trading is about speed and processing information as quickly as possible without delays. High frequency trading software is well adept at performing these operations better than a human could.
The price movements usually last for a few minutes. However, combined with the large volume HFT produces, it’s no wonder why HFT firms trade the news.
Spoofing and layering
High frequency forex strategies have been criticised for manipulative and illegal tactics like spoofing and layering. While the two are slightly different, they aim to deceive the market with ‘fake’ orders to push the price in a particular direction.
Spoofing is canceling before execution. It involves placing massive pending orders to attract one side of the market. Then, when the market reaches near the price, the ‘spoofer’ will cancel the execution.
This action would drive the market in the direction of the order. So, for buy orders, the price would go up; for sell orders, it would go down. At this point, high frequency trading software can enter the market at a favorable top or bottom, resulting in higher profits.
Layering is a type of spoofing with the same goal of gaining favorable entries. Here, the trader ‘layers’ or places massive orders at multiple close-by price tiers. This causes the spread’s midpoint to move away, allowing the trader to execute positions in the opposite direction.
Fortunately, there are rarely publicised cases of spoofing and layering in FX. But these are things that high frequency trading software is capable of producing.
The image above describes how market-making works. High frequency currency trading makes FX run more efficiently than ever before.
A market maker or liquidity provider should always have an ‘inventory’ of currency pairs they can trade instantly. Adding an element of high frequency improves the speed and volume. By enhancing liquidity, traders receive cheaper spreads, better pricing and reduced slippage.
The impact of high frequency currency trading
Truthfully, HFT-based trading is less documented in forex compared to other instruments, most notably stocks from the United States. One reason is that forex high frequency trading is reserved only for a few due to the expensive tools required.
Also, despite how it offers the big players an edge, it’s not without risks. These factors decrease the profitability or worthwhileness of a high frequency forex trading strategy. Finally, let’s remember the competition.
Another problem is detection. It is nearly impossible to conclude whether HFT caused a large pip movement or not because of the decentralized nature of FX.
Flash crashes are rare events in any traded market. And even then, there is never a conclusive report with evidence of HFT, only speculation.
For instance, let’s look at the flash crash of October 2016 on GBP/USD. This was a highly volatile period for the pair, as it was during Brexit. The price fell by almost 8% in two minutes on this chart below.
To this day, no research has provided a definite answer on why this happened. Yet, many theories revolved around forex high frequency trading reacting to negative news at the time.
We can assume that only an advanced computer would have been capable of such an unexpected drop. However, such events are few and far between.
Therefore, retail traders shouldn’t yet worry about HFT because we rarely experience its negative effects.
Can retail traders use high frequency trading software?
Of course, anyone can technically invest in such software. But the long answer is no because it’s expensive!! Although we couldn’t find actual figures, our research suggests starting prices from $200 000 (or $10 000 monthly), but this isn’t all.
Forex high frequency trading needs a data provider, for which you pay at least $5000 monthly. Additionally, a dedicated server can set you back a further $2000 monthly at best.
Oh, let’s not forget that you’d probably need a trading account with a couple of million dollars to make any high frequency trading strategy worthwhile. Unless you’re Bill Gates, HFT is reserved for elite financial institutions for a reason.
Forex high frequency trading is only a subset of automation or robots in FX. We have only scratched the surface, considering that AI will also become influential in the near future.
But what about right now?
As we mentioned previously, HFT isn’t a threat in the current trading climate. For now, we can only implement strong risk or money management, along with an edge-defining strategy, to find success in the markets.