High-Frequency Trading Explained: What Is It and How Do You Get Started?

High-frequency trading involves using powerful computers to make a large volume of trades in a short span of time. Here, our expert explains the basic principles and outlines how to get started.

Written by Alex Williams
Published on Jan. 25, 2023
High-Frequency Trading Explained: What Is It and How Do You Get Started?
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Traders can adopt countless styles in their work, but one of the most controversial and fascinating ones is high-frequency trading or HFT. You might have already heard about it in passing but want to learn more. 

So, what is high-frequency trading? Could this style be right for you? Let’s take a look at what it entails and its various pros and cons.

What is high-frequency trading?

High-frequency trading is a type of automated trading that uses powerful computers to buy and sell financial assets incredibly quickly. The term “high frequency” refers to how quickly these trades are completed. They may take place in minutes, seconds or even milliseconds!

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What Is High-Frequency Trading?

High-frequency trading is a type of automated trading that uses powerful computers to buy and sell financial assets incredibly quickly. The term “high frequency” refers to how quickly these trades are completed. They may take place in minutes, seconds or even milliseconds!

Why do investors trade at such speeds? Because high-frequency traders use sophisticated algorithms to analyze data from various sources, they can find profitable price patterns and act fast. 

This type of automated trading has grown exponentially in recent years because technological advances have allowed more players to engage in it.


What Are the Benefits of High-Frequency Trading?

HFT has become so prevalent that it’s frequently cited as a major contributor to the stock markets volatility. 

Generally speaking, HFT has two noteworthy benefits: 

What Are the Benefits of High-Frequency Trading?

  • The elimination of excessively small bid-ask spreads. In the stock market, a bid-ask spread refers to the difference between what somebody is willing to pay for an asset and what others are asking for. It allows institutions to earn profits from differences in price. 
  • Improvement in overall market liquidity. Higher HFT fees result in greater disparities between the bid and ask prices. Increased liquidity tends to reduce the gap between prices of bid and ask orders, making markets more efficient.

A study examined how the implementation of HFT fees in Canada affected bid-ask spreads. According to data, the spread paid by retail investors increased by 9 percent, while charges to institutional traders rose 13 percent. HFT has reduced the bid-ask spreads to near zero.


What Are the Drawbacks of High-Frequency Trading?

In the past decade, high-frequency trading has become a major force in financial markets. The increased use of HFT has been met with considerable criticism, however. 

The method relies on mathematical models and computers rather than human judgment and interaction and has replaced a number of broker-dealers. This means decisions in HFT happen in split seconds, which can result in surprisingly big market fluctuations. For example, on May 6, 2010, the DJIA lost 1,000 points, or 10 percent, in just 20 minutes, the largest intraday point decrease in DJIA history. Following their own investigation, government authorities found that the crash was caused by a massive order, which triggered a selling frenzy.

Another concern about HFT is that it gives an unfair advantage to large financial institutions over individual investors. Individual, small investors are at a disadvantage because they lack the resources and speed to process information as efficiently as high-frequency trading computers.

Critics also object to HFT’s phantom liquidity (which refers to its ability to appear and disappear quickly), arguing that it makes markets less stable. Phantom liquidity is one of the outcomes of low-latency activities in high-speed friendly exchange structures. It emerges when a single trader — an HFT specifically — places duplicate orders in multiple venues.


Recent Changes in High-Frequency Trading

The world of trading has undergone a dramatic shift in recent years. The introduction of high-frequency trading (HFT) tactics has changed the landscape for traders, investors, and corporations. These include:

How Has High-Frequency Trading Affected the Market?

  • The markets for foreign exchange, exchange-traded funds, and commodities trading are now using HFT. Small investors and corporations dramatically grew with the introduction of HFT, while giant, established corporations like Virtu Financial and Citadel Services have dominated the market.
  • Increased commercial activity, such as fast trade execution, a large number of transactions, and new competitors, like fintech companies that provided greater accessibility for people seeking financial services, have fueled competition against traditional banks.
  • HFT is shifting from just trading using computer programs to areas like cloud computing and artificial intelligence (AI). 


How to Get Started With High-Frequency Trading

When you’re a high-frequency trader, speed is the name of the game. You want to be able to get in and out of the market as quickly as possible so you can make your next move before anyone else even knows what happened.

But how do you start? Where do you even begin? Here are five tips for getting started with high-frequency trading:


An Overview of HFT Systems

When building an HFT system, consider how to make it fault-tolerant and scalable. A sophisticated system must handle many types of failure without disrupting its operations. Malicious agents in high-risk situations can cause DDOSes by disrupting market access for others.

In a microservice architecture, different components in the system should be able to run on different servers. This allows you to scale by adding more servers as needed. 

When trading live, your system will encounter errors. Some might be related to third-party issues like broker DDOS attacks. Such an attack involves flooding a targeted network or server with internet traffic to the point that its normal operations are disrupted. When using a microservice design, schedulers aim to reboot a failing service quickly. 

In highly volatile scenarios, malevolent agents may initiate DDOS attacks to obstruct others access to the market, causing your scrapper to fail. The microservice architecture is designed to be fault tolerant. If a single service fails, the system can keep functioning without it. This setup makes it easier for you to troubleshoot and fix issues as they arise.


The Components of an HFT System

The components of an HFT system include the database, scrapper, quantitative model, order executer, and quantitative analysis.

What Are the Components of a High-Frequency Trading System?

  • Database — The high-density time series database must handle hundreds of thousands of data insertions every day. It must also be scalable to execute high-speed resampling in an immutable and distributed manner.
  • Scrapper — The scrapper updates the database with the latest streamed data.
  • Quantitative Model — This represents market interaction. When markets aren’t liquid, you become prone to slippage. Slippage, which occurs at any time in the market and affects all traders, is defined as the difference between expected and actual prices.
  • Order Executer — You need a good microsystem to execute your positions well. Instead of market orders, you can execute limit orders, which take longer and may need to be modified depending on market liquidity. With limit orders, you can set a price that is the highest at which you want to buy shares. Your order may not be executed if the market trades above or below this level. 
  • Quantitative Analysis — Analysts can customize the tools they use to their needs: many types of graphs help reveal data, but histograms that show ranges are also ideal for this purpose. Linear regressions, which help determine whether a correlation exists between sets, can provide another way to see relationships. Thanks to Python-based tools like Streamlit, analysts can now easily generate their own models. With such convenient techniques and advanced technology, it has never been easier for researchers to conduct quantitative analysis.

For example, you cant guarantee full market access in fluctuating market conditions (such as during high volatility and low liquidity periods).

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Try High-Frequency Trading for Yourself

High-frequency trading is a growing phenomenon in the financial world, but it’s been around for several years. It involves using computer algorithms to place trades at a very high rate of speed, often within a fraction of a second. This enables larger profits when done correctly, but it also comes with many risks that can result in massive losses. 

Investors must be careful not to succumb to the temptation of taking these risks without fully understanding them and their potential outcomes. This is why its important for investors to learn more about high-frequency trading before deciding if they want to participate in it.

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