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To understand how high-frequency trading works and what its advantages are, we can take a look at several defining factors that make this trading strategy unique and complex.
HFT firms usually focus on instruments such as forex and options, which are characterized by high liquidity and fast returns.
As already mentioned, HFT involves an extremely high number of trades per session and incremental profits add up by the end of the session and over time.
Speed
HTF traders rely on the speed of their trading systems to gain an advantage in the market.
They use low-latency, high-speed data connections to exchange information with trading venues, allowing them to execute trades within microseconds.
The goal is to take advantage of small price discrepancies that exist for very brief moments.
This is especially convenient in the forex market, which is the most liquid market in the world.
HFT traders typically focus on major currency pairs as they offer unparalleled liquidity and tight spreads.
Complex Algorithms
HTF trading systems use sophisticated algorithms to identify trading opportunities and make decisions in real-time.
These algorithms are designed to analyze market data, such as price movements, order book changes, and other relevant information, to execute trades.
Constructing them can be very costly, which makes HFT a market with a high barrier to entry.
Market Making
Some HTF traders act as market makers, providing liquidity to the market by continuously quoting bid and ask prices.
They profit from the spread between the buying and selling prices. By quickly adjusting their quotes in response to market conditions, they can capture small profits from each trade.
Due to the outsized liquidity of the assets HFT traders typically transact in, the market adds even more liquidity courtesy of such trading firms.
Arbitrage
HTF traders often engage in arbitrage strategies. They identify price disparities between different markets or assets and exploit these discrepancies by buying low and selling high, or vice versa, within a fraction of a second.
This makes the markets they are operating in more efficient and spreads are tighter for every market participant.
Risk Management
HTF traders have strict risk management systems in place. They use various risk controls and circuit breakers to limit potential losses and prevent catastrophic trading errors.
HFT requires a constant electricity supp-ly to run smoothly and the internet connection must be as fast and secure as possible, which is why HFT firms choose high-proximity areas to bae their trading hardware and servers.
Co-location
As mentioned above, HFT firms tend to choose areas that are in close proximity to the trading floor and server rooms of the exchange they are trading on to reduce latency and get an ever so slight edge over the competition.
Market Impact
The rapid trading activity of HTF firms can influence market dynamics, as their large order flow can impact prices and liquidity. This influence can be both positive and negative for other market participants.
While this increases liquidity, it can also eat into the opportunities of retail traders, which has been a topic of contention since the advent of HFT on the market.
