As a trader or investor, you have likely heard about the concept of high frequency trading.  However, very few traders realize how to beat high frequency trading in the stock market.

Let’s take a deep dive into this article on how you can gain an edge and use HFT to your advantage.

Understanding High Frequency Trading

The stock market is constantly evolving.

The open outcry or pit trading was the preferred method of exchanging securities and commodities.

Since the 1980’s however, markets transitioned to electronic trading.  This wiped out a lot of floor traders in the pits and simultaneously empowered individual investors to have the same opportunities sitting at home in their pyjamas.

The next step of the stock market evolution is high frequency trading.  It was only a matter of time before computer code and programs began to trade on behalf of humans.

I highly doubt that machine code will replace human traders in the near future, as we are in the business of valuing assets based on human emotions.  This is not likely to change, ever.

High frequency trading is simply the execution of trades at a high frequency by an algorithm, on a computer.  There is not one “HFT” out there that is after your stop loss.

 

If you really want to understand how high frequency trading works, click here to check out this article on latency arbitrage.

Another great resource for a deeper dive into the topic of high frequency trading is the Michael Lewis book titled Flash Boys.  You can have a sneak peek of the book here.

However, at this point, let’s move forward and explain a few ways that high frequency trading strategies make money in the stock market.

 

Dark Pools

Dark pools are private exchanges for trading securities.  They are called dark because a retail trader and the investing public cannot see the trading book with the orders.  Algorithms and high frequency traders make money by purchasing order flow from brokerage companies and using their speed advantage to transact on latency arbitrage.  Brokerages, like Robinhood, sell customers orders to these dark pools for profit (read the story here).  This is how they offer “commission free trading”.  Everyone wins, at the expense of you, the client, of course.

Market Making – Bid Ask Spreads

Another popular high frequency trading strategy is to post limit orders on both the bid and the ask.  Depending on the order in which they get filled, a firm effectively scalps ticks at a time.  The profit is extremely small, and oftentimes so is the trade size.  However, when you repeat the frequency by a couple of million shares, the profits multiply very quickly.  Companies like Citadel and Virtu Financial are big players in this industry.

Arbitrage Trading Strategies

Arbitrage is the ability to earn a guaranteed profit by simultaneously buying and selling assets that are mispriced.  By use of futures, stocks, and even currencies – traders can earn a guaranteed profit by taking multiple positions.  This strategy was once possible to human traders, but it now requires a very fast execution only possible with high frequency algorithms.

 

This is just a brief summary of the more popular high frequency trading strategies.  There are hundreds, and thousands of programs designed to exploit certain edges.

In addition, there is an equal number of algorithms programmed exclusively to take advantage of these very same algorithms.  It is like a battle between machines.  A terminator analogy is very appropriate here.

In fact, the high frequency trading landscape is constantly getting more competitive.  It is costing more money to run these programs, as they are now fighting each other.  The competitive landscape has caused a lot of computer trading companies to exit the business altogether.

But how does all this affect you?

And, most importantly, how can you beat the high frequency trading?

High Frequency Trading Doesn’t Hurt Most Retail Traders

One of the most important things to realize, is that algorithmic trading is causing you less impact than you might think.

If you are a long term investor the impact is negligible.  Also, if you are a more active trader and take a few trades a day, you are not impacted either.

So who is at risk?

Scalpers.  These traders rely on their speed to execute dozens of trades a day to lock in small gains in high frequency.  Scalping has become next to impossible to do consistently, and is very stressful.

For the everyday trader, algorithmic trading and high frequency algorithms actually help us by providing us an opportunity to get filled (liquidity).

Let’s talk about how you can take advantage and how to beat high frequency trading.

 

How to Beat High Frequency Trading

Imagine you are able to see every single order in the book at all times?

Would you be able to gain an edge on the market?

Of course!

This is exactly why we trade futures because they are listed on a centralized exchange and all traders have to post their orders in the same market.  No dark pools, no nonsense.  Futures are a transparent marketplace, also called a lit market.

Here is an example of what it looks like to see a heatmap of all currently open markets on the gold futures market.

 

futures market

 

The image above shows what can happen when you are tracking the book of orders.  You can see that being able to see the large sell orders allowed us to take a short trade, and continue to ride it down to the big buy levels below.

This helps a trader maximize their profit, and also trade on the strong side of a market.

Now let’s take a look at one more image of a unique “order flow” chart called the footprint.  This chart shows you where there is big market buying (green) and big market selling (red).   As you can see below, the footprint chart helped us pinpoint when market buying came in and when to exit as large market selling came in, turning the tide.

 

strong side of a market

 

All of these tools are part of “order flow analysis”, and we teach these principles in full in our futures trading course.  You can get access at a very low cost now by choosing a membership package here.  All of our memberships include the futures course.  You can start now, and learn how to read the markets like a professional.

Once you start using the order flow, you will see the stock market in a new light.  You will also start to notice recurring patterns that you can exploit and gain an edge.  This is how you can beat the high frequency trading algorithms.

I look forward to seeing you in our community and live day trading room.

 

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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.