When Paul Julius Reuter began sending stock market quotations between London and Paris in 1851 via a cable underneath the English Channel he reflected a need for speed that has persisted with the markets.
It was bad news for the poor old carrier pigeons who used to take the stock prices but better news for investors who wanted to be able to swiftly react to events.
Still, the move from pigeons might have added some speed but the real revolution in this regard came in the last decade or so. The hustle and bustle of the trading floors has largely been replacing by low and persistent hum of computer data centres, which first operated side-by-side with their traditional counterparts for a while before edging them out. Yes, the New York Stock Exchange still stands proudly in Manhattan but, as the FT notes, the real work is going on in suburban Mahwah, New Jersey, at a data centre.
These data centres allow for what’s known as high frequency trading (HFT), with the vast bulk of deals in equities and futures executed by machines, allowing the process to be automated and the calculations to be made at a rapid rate on a great scale. The time it took you to read that last sentence could be used to make thousands of trades by a computer. On those numbers, you can see why humans don’t stand much of a chance in competition, let alone the poor pigeons. Put simply, it’s about finding effective way to carry out a lot of trades in a very short space of time.
The shift to computer-based trading prompted a big rush to invest in talented – and expensive – coders and the sort of hardware required to create networks capable of crunching big numbers in a tiny space of time. HFT has emerged as a subset of this wider trend – known as algorithmic trading – capitalising on the benefits of automation and rolling them out to a scale, scope and speed that can be crucial to the success of a trade.
It’s easy, therefore, to see why HFT is of great use in the forex market. UK-based traders used to looking at the gold market or FTSE 100 might not be used to the fast pace and the volatility of forex, the world’s largest and most liquid market, but anyone engaged in currency will appreciate this as part of its attraction as an investment.
Everyone engaged in forex will know that this price volatility – in a 24/7 market – can be prompted by a whole host of factors – politics, weather, criminal activity, economics etc. Being able to predict what this will do to a currency pair can be greatly helped by a detailed and in-depth understanding of the past, which is where algorithms come in. HFT relies on being able to take that data and act on it at scale. Programs are designed to be able to act upon small movements in currency prices, the sort of movement that would make mere pennies at a small scale but could deliver bigger returns when the trades are numbered in the millions. This is how a jump of a fraction of penny up or down could result in large returns for investors and, given the movement in the market when it comes to forex, that means that the right algorithm, with a fast enough connection can identify and react to many different opportunities in a single day, let alone a week or month.
HFT forex trading is, therefore, an exaggerated form of standard forex trading, using complicated algorithms to make big trading opportunities from the smallest of movements. Forex is a market defined by the constant flow of such movements, making it the perfect choice to apply these principles. Yet, while the opportunity is exaggerated, so too is the risk, which is why it is so important to perfect the algorithms that underpin the trading choices. A big mistake at a grand scale can be every bit as bad as a smart choice at scale. Risk and liquidity define the forex market, HFT techniques accentuate both of these.