High-frequency World In The Forex Market

High-frequency trading (HFT) is a new sophisticated type of trading that involves supercomputer power and ultrafast algorithms, which solve the price action and the news-feed in a matter of microseconds. It arises firstly in the stock market, where a lot of algorithmic trading desks exploit the order flow inefficiencies and compete for the bid/ask spread in a broad range of actively traded stocks. In 2010 over 70% of the US equity trading volume is considered to be driven by these algorithmic strategies. But what is the situation in the forex market? Is there anything similar or not? We will discover in this paper that in forex this segment of the active trading participants grow very fast and soon will determine the rules in the whole market!

High-frequency trading (HFT) is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:

- HFT is highly quantitative, employing computerized algorithms to analyze incoming market data and implement proprietary trading strategies;

-HFT usually implies a firm holds an investment position only for very brief periods of time - even just seconds - and rapidly trades into and out of those positions, sometimes thousands or tens of thousands of times a day;

- HFT firms typically end a trading day with no net investment position in the securities they trade;

-HFT operations are usually found in proprietary firms or on proprietary trading desks in larger, diversified firms;

-HFT strategies are usually very sensitive to the processing speed of markets and of their own access to the market.

In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours. High-frequency trading (HFT) uses computer programs and sometimes specialised hardware ^[3] to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability. High-frequency traders compete on a basis of speed with other high-frequency traders, not long-term investors (who typically look for opportunities over a period of weeks, months, or years), and compete with each other for very small, consistent profits.  As a result, high-frequency trading has been shown to have a potential Sharpe ratio (measure of reward per unit of risk) thousands of times higher than the traditional buy-and-hold strategies. By 2010 high-frequency trading accounted for over 70% of equity trades taking place in the US and was rapidly growing in popularity in Europe and Asia. Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day. High-frequency trading firms do not employ significant leverage, do not accumulate positions, and typically liquidate their entire portfolios on a daily basis.

One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity. An academic study shows additional benefits, including lowering the costs of trading increasing the informativeness of quotes, improved linkage between markets,  and other positive spillover effects, at least in quiescent or stable markets; the authors of this study also note that "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward. Also noteworthy is that HFT only takes place in markets that are already deemed liquid, hence calling its necessity into question.

Algorithmic and high-frequency trading were both implicated in the May 6, 2010 Flash Crash, when high-frequency liquidity providers were in fact found to have withdrawn from the market. A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010." 

The HFT firms in the forex market operate with small trade size, but very large volume of transactions. The typical period of holding the open position is very short, approximately less than five seconds and often under one second. In the forex market the HFT is a bit slower than in the equity market, because the market is decentralized and the liquidity is aggregated from all over the world, so the speed of light is the limit in order execution. In most cases this means several milliseconds. Typically the time for trade execution is 10 to 30 milliseconds, but in some cases it is as little as one millisecond.

There are several benefits from the operation of HFT firms in the forex market, but the most important of them is that HFT helps for the distribution of the liquidity across all the market places, thus improving the efficiency of the market itself and help for narrowing spreads.

There are a broad range of strategies, which are involved in the HFT. Some of the more classical ones are:

- Arbitrage between three or more pairs (for example EUR/USD, USD/GBP and EUR/GBP). This strategy is well known for decades, but now it is exploited by ultrafast algorithms, which could see the arbitrage opportunity and execute it in a matter of several milliseconds.

- There are a number of strategies that are involved in a direct liquidity providing, thus aiming to capture the bid/ask spread. These are a market making HFT strategies.

-Some players in HFT use latency arbitrage strategies, aiming to gain from the slower price change in the platforms of some market makers, compared to other platforms.

 In the last years it arise a full range of new and more complex strategies that utilize more sophisticated algorithms to process complex events and follow a lot more market indicators. They use statistical models for price momentum, mean-reversions, correlations between pairs and also with other assets, like bonds and futures. There are even some strategies that process news information and economic data and could react very quickly to it.  Most of the HFT participants are prepared to work in most liquid markets, like the major currency pairs in low volatility conditions, but some of them are prepared also for the volatile market conditions.

The platforms, which are mainly used by the HFT participants, are ECNs (electronic communication networks), which aggregate liquidity from multiple banks and dealers. An example of such an ECN is the Dukascopy Swiss FX Marketplace, which combine liquidity from biggest marketplaces (Currenex, Hotspot FX, Lava FX) and banks in the world (Bank Of America, Deutsche Bank, JP Morgan, UBS, Goldman Sachs, Citibank and a lot more). In such an environment it is very easy to compete with other participants and to implement your strategy. In comparison with old interdealer providers, which often restrict the number of price quotes per second, in ECN environment there is no such restriction, because it can handle a big amount of data through its APIs and messaging standards (like frequently used FIX protocol).

The other important thing for starting a HFT venture is to have access to tick history data, in order to backtest and check the functionality of your HFT algorithms. In my opinion Dukascopy Bank is the one of the very few, if the only one forex prime broker, providing such a valuable information for free! Thus for me it is a place to start a HFT venture. In some of my future articles I will discuss more in depth the algorithms and their implementation in order to have a fully functional HFT, which is one of my big dreams!