Many trading strategies appear to be profitable to cryptocurrency traders, but a few promise an edge over the rest. One such example is high-frequency trading, though it’s evident that it may or may not be perfect for everyone.
In this guide, we’ll explain the ins and outs of high-frequency trading. But do note that this approach doesn’t necessarily guarantee success, as it also assumes that you have the skill set to use it. So, if you’re keen on understanding the HFT crypto concept to ultimately apply this strategy, here’s precisely what you need to know.
What Is High-Frequency Trading (HFT)?
High-frequency trading (HFT) is a type of algorithmic trading that involves high-speed trade execution in fractions of a second. As the name suggests, HFT is all about speed.
This technique uses various algorithms to analyze the smallest price changes and discrepancies between the same asset prices on multiple exchanges. Typically, HFT platforms and systems can automatically open and close several positions per second, aiming for short-term goals that would otherwise go unnoticed by the naked eye.
Traditionally, this technique applies to foreign exchange (forex), stock, and other markets. However, over time, high-frequency trading has gained traction in the crypto space, mainly because of the multiple trades per second that can offer a slew of benefits.
Institutional investors largely employ this mETHod and of course, there are also specialized services that provide HFT platforms for institutional investors to help them benefit from the high volatility of cryptocurrencies.
Key Aspects of HFT
Although the U.S. Securities and Exchange Commission doesn’t use a clear definition of high-frequency trading, it stresses five key aspects of high-frequency trading:
- The use of high-speed and complex programs for generating and executing orders.
- Use of colocation services offered by exchanges and other services to reduce potential delays and latencies in the data flow.
- Utilization of very short time frames for opening and liquidating positions.
- Submission of multiple orders that are canceled shortly after submission.
- Avoiding overnight risk.
All in all, HFT is an integral and crucial part of all markets. That includes cryptocurrency, even though most retail traders aren’t aware of its contribution. They’re interested in generating more profits with little effort, and HFT seems ideal for achieving this.
However, HFT strategies’ success depends to a large extent on the algorithms and equipment used. Sadly, the reality is that typically, institutional investors are the ones who are capable of accessing the best algorithms.
How Does High-Frequency Trading Work?
As you can guess, there’s a lot of automation involved in the HFT process. But not everyone can use this mETHod. In a nutshell, the computers used to conduct high-frequency trading are programmed to host sophisticated algorithms, which continuously analyze all cryptocurrencies across multiple exchanges by millisecond.
The algorithms are created by trading experts and are designed to detect trends and other trading triggers that other traders cannot observe, no matter how professional they are. Based on analysis, the programs automatically open a large number of positions at high speed. The main goal is to be the first to benefit from the emerging trends detected by the algorithm.
Generally, the algorithms used by high-frequency traders are built to scour these price moves and to trade on the opposite side. For instance, a large sale of a cryptocurrency might drag prices down. But the algorithms “buy the dip” and exit the positions when the cryptocurrency bounces back to normal.
Note that we’re not discussing sizable price moves but rather short-term anomalies caused by large traders – when a large institution or whale opens a large long or short position on a particular cryptocurrency, the price tends to follow the position’s side after the trade. In addition, algorithms can use different strategies besides going the opposite way.
Example of HFT Crypto
High-frequency trading (HFT) seeks to take advantage of small price fluctuations to exploit the bid-ask spread. The bid-ask spread is simply the difference between the price at which you buy and the lowest price at which you’re able to sell.
When you buy a cryptocurrency like Bitcoin, you’re not paying the market price; rather, you’re hitting the ask price, which is higher than the market price. Conversely, if you sell Bitcoin, you’ll be paid the bid price, which is lower than the current market price.
Here’s an example:
- Bitcoin ask price: $34,500
- Bitcoin bid price: $34,450
The bid-ask spread, in this case, is $50. The HFT algorithms will seek attractive bid-ask spreads that they can exploit.
While each of these HF trades generates small amounts of profits, executing thousands of them can make it a very profitable strategy. Many other HFT strategies, such as arbitrage or HFT programs, seek discrepancies in prices that aren’t visible to the human eye.
Is HFT Applicable to Crypto Trading?
High frequency can be applied to cryptocurrency trading, but not everyone can execute it. The scope and capability of HFT in crypto trading are similar to that seen in traditional markets. However, the crypto space is more volatile, full of opportunities and risks.
One of the basic HFT practices used in the crypto space is colocation. Colocation is used when a trading server is placed as close to an exchange’s data center as possible. Ideally, the server is found in the same facility as the exchange, ensuring minimum latency in data transmission. While the slight delays in data transmission for retail traders are not so significant, every millisecond can make a difference for institutional traders.
Besides colocation, HFT algorithms are commonly used for arbitrage and short-term trading in cryptocurrency markets.
When to Use HFT for Crypto?
You can use high-frequency trading once you’ve made sure that the promoted trading algorithm is 100% efficient – and isn’t a scam. Note that even a reliable algorithm is only as dependable as the person who created it. So it makes sense to conduct due diligence before engaging in high-frequency trading. Once you find the algorithm that best suits your needs, you can engage in HFT when you feel ready.
Is High-Frequency Trading for Everyone?
HFT has become technically available for everyone, as there are advanced algorithms that everyone can access for a price. However, beginners need to be extra cautious when executing it. As such, HFT is more suitable for institutional investors who understand the market and know how to deal with unexpected outcomes.
The best recommendation would be to stick with manual trading to gain experience and understand the market. Perhaps traders should start with crypto day trading, slowly refine their strategies, and eventually work their way up to HFT.
Closing Thoughts
WhETHer or not HFT crypto is causing ghost liquidity, or benefiting institutional investors substantially, ultimately, it’s all about the goal and how it’s applied. Instead of focusing on the potential negative impact on the overall market, traders may regard HFT as a potential opportunity.
