What is High Frequency Trading in Crypto?

High-frequency trading (HFT) in crypto involves buying or selling cryptocurrencies at an extremely rapid rate with the aid of computer programs. Because these buy-and-sell" trading opportunities could disappear within seconds, AI programs and complex algorithms are needed to execute trades.

High-frequency trading is one of the many trading strategies utilized in the stock and financial markets, and it can be replicated in cryptocurrency trading. The success of the strategy depends, to a large extent, on the market data and the effectiveness of the computer algorithm. The complex tools utilized in algorithmic trading are often designed by a trading expert cum programmer.

The best algorithmic trading tools work almost at the speed of light and have a high success rate, enabling high-frequency traders to profit from buy-and-sell opportunities in the crypto markets. Notably, this trading strategy is mainly used by institutional traders rather than retail traders.

High-Frequency Crypto Trading: How Does it Work?

Five steps are involved in executing high-frequency trading in the cryptocurrency market. They are;

Exchange Integration

The first step is integrating your desired crypto exchange with the high-frequency trading platform. Many centralized and decentralized exchanges have APIs that support external integration with trading tools. Once you have integrated the crypto exchange with an HFT algorithm, you've laid the groundwork for seamless algorithmic trading.

Colocation

This involves setting up a trading server close to a crypto exchange's data center. Data is transmitted faster when the trading server is closer to the data center. Some institutions set up their servers in the same facility as the exchange. Since HFT strategies involve capturing the price difference in split seconds, the proximity of the server could make a big difference in the strategy's effectiveness, especially if it involves numerous trades.

Trade Execution (Algorithmic Trading)

The next step in high-frequency trading is trade execution. Buy and sell orders are opened using short time frames. HFT traders typically set up the algorithm to open and close positions within a few minutes, seconds, or even nano-seconds jump trading them.

Order Submission and Cancellation

The algorithm often submits multiple orders, in large volumes, which are canceled shortly after submission. Market makers create multiple orders to influence the market perception of demand and supply, which is a form of market manipulation.

Reducing Overnight Risk

When implementing high-frequency trading in the cryptocurrency market, HFT traders ensure no overnight positions are held. This is a form of risk management, as the crypto market is extremely volatile, and overnight positions could be liquidated.

The Most Popular High-Frequency Trading Strategies

Here are five of the most popular HFT strategies in the crypto market.

Crypto Arbitrage

Crypto arbitrage involves buying a cryptocurrency from one market and selling it almost immediately in a different market where the asset's price is slightly higher. Price differences often disappear within a few minutes or seconds. This explains why high-frequency trading algorithms are required to maximize profits when executing crypto arbitrage.

The prices of tokens in the crypto market typically vary slightly from exchange to exchange. For example, Bitcoin may be valued at $63,900 at 9:00 a.m. on Coinbase, while at that exact time, it is valued at $63,868 on Binance. An arbitrageur identifying this discrepancy may want to buy BTC on Binance and sell it on Coinbase, instantly profiting from the price difference.

HFT algorithms help traders profit from price differences across multiple exchanges. Arbitrageurs' activity helps balance demand and supply, closing the price gap.

Scalping

Scalping involves buying a cryptocurrency or digital asset and selling it as soon as you make small profits. For example, a trader may buy Ether at $2,765 and sell it once the price reaches $2,768, making a $3 gain. However, this process is usually repeated several times to maximize gains from price movements in the crypto market.

Scalping is one of the trading strategies that syncs well with high-frequency trading. Crypto traders need to be fast when scalping to limit risk exposure in the crypto market. With HFT algorithms, scalping can be more efficient. A trader could be aided by sophisticated algorithms rather than manually buying and selling digital assets.

Short-term Technical Patterns

HFT algorithmic trading strategies can be augmented with technical tools. For example, the MACD indicator and the Relative Strength Index (RSI) could be added to an HFT algorithm to trigger a buy order whenever the MACD line crosses from beneath and the RSI is below 30%. With the aid of an HFT algorithm, trades can be executed at high speeds, allowing market participants to maximize profits.

HFT firms, hedge funds and individual traders implement this technique for short-term price movements. The strategy cannot be used for swing trading and long-term investment.

Momentum Trading

Retail and institutional traders implement momentum strategies to maximize profit. Momentum trading involves trading with the trend or flowing with the current market sentiment. An HFT algorithm scans for high trading activity and increased volatility to get the most out of this strategy. Once the algorithm spots breakouts or drawdowns, it joins the trend automatically.

Market Making Opportunities

Crypto exchanges need multiple liquidity providers to optimize the crypto trading experience. CEXs sometimes collaborate with specific market makers to create buy and sell orders. Liquidity providers add liquidity to the exchange and profit from traders' trading fees, which is the difference between the bid and ask price. High-frequency trading algorithms can be integrated with market making.

The Pros and Cons of HFT

Pros

• Market efficiency: High-frequency trading improves market efficiency. Market making contributes to the trading volume in the cryptocurrency market. Swift buying and selling balances demand with supply, making the market conditions favorable for retail traders and institutional investors.
• Swift execution: HFT traders benefit from the speedy execution of trades. The rate of trade execution ensures that traders do not miss out on market movements and potential opportunities to earn.
• Automation: The scope of manual trading is very limited. Automated trading aided by AI algorithms gives traders a hands-free experience while maintaining high accuracy. Further, implementing algorithmic HFT strategies eliminates emotional or human errors.

Cons

• High Risk: The risk-reward ratio is usually high for high-frequency trading strategies. HFT traders can potentially incur larger losses than other traders, and a loophole in the algorithm could lead to a significant loss.
• Potential for market manipulation: Market manipulation is common in high-frequency trading. HFT firms may capitalize on their asset volume to create orders that could mislead market participants.

Conclusion

High-frequency traders benefit from market fluctuations in real-time. With a highly accurate algorithm, they can profit from market liquidity in the cryptocurrency markets. Further, high-frequency trading (HFT) eliminates errors due to human emotions since it is a purely electronic form of trading.

In the same way, high-frequency trading can be very risky. If done wrong, you could lose all your digital assets in record time. HF traders should employ proper data analysis and risk management strategies before implementing a high-frequency trading strategy.