One of the most common questions I receive when discussing day trading futures is along the lines of ‘but don’t HFTs make it impossible for futures day traders to make money?’
Like many topics in this industry, most traders know something about HFTs but they don’t know the full story. So let’s investigate HFTs a little more. For the purpose of this article I am referring to HFTs in the futures industry.
This article was co-authored by Rob from Discovery Trading Group an industry veteran and one of the best in the business.
What are HFTs?
First we need to understand what an HFT is. HFT stands for High Frequency Trading and typically refers to a firm rather than an individual. The HFT firm sets up automated trading rules using algorithms and as its name suggests, looks for high frequency styles of trading. Trades will be exited quickly with trade times measured in the fractions of seconds. The algorithm will aim to trade up to hundreds of thousands of times a day.
It is often widely assumed that HFTs trade as market makers. However, while there are aspects of their trading that resemble a market making style, in my experience, many of them do not fully utilise market making methods. This comes back to the fact that market making is misunderstood (see my previous article here)
Why are people scared?
Traders are told to have fears over HFTs because ‘how can a human compete with an algorithm trading at such high speed?’ So we are told that it is pointless for us to try to manually trade in a high frequency way because the HFTs will have taken all of that edge.
Are they really competing with us?
I have already noted that many HFTs are not trading in a classical market making style; they are some missing areas in how they operate. So this is one aspect of where we might not be competing with them.
We can’t even see the timeframe they trade in
HFTs are trading in timeframes that are significantly smaller than the rest of us which means that we might not be competing for the same trades. In the same way that someone trading for 2 seconds can trade against someone who has a 3 hour timeframe and both could profit.
The reality is that we can’t even see the timeframe that HFTs are trading in (micro-seconds) so it is extremely unlikely that they are stealing our trades. In the time it takes you to blink they have already traded.
The micro second timeframe in which HFTs operate means that they simply cannot rely on or base their trading around, retail flow; it is too slow and infrequent. In fact, they are typically trading against each other.
They get in early
A key strategy for many HFTs is to load up their orders into the order book in the pre-market. Again they are typically competing with each other in this regard.
A key aspect of the Norden Method style is to pick off trades that were placed with a different context. These HFT pre-market orders would count as such and so we should not fear trading against these either.
Are they actively trying to move the market?
Some suggest that HFTs try to move the market against retail traders. How often have you heard someone say something along the lines of ‘they are trying to trap you’? This idea doesn’t hold up to scrutiny.
The whole premise behind HFTs as the name suggests is to focus on frequency. HFTs don’t want to be position takers who expose themselves to market moves for any longer than they have to. As we have seen, they are actually trading for micro seconds and typically for a one tick profit or scratch.
So they have no interest in being an active player trying to move the market.
They will also be trading small size, usually one to five contracts. Again they simply don’t have the exposure or desire that requires them to try and move a market.
The game is simple; small size; high frequency; in and out asap.
It’s a numbers game
One significant area of knowledge weakness for retail traders (and most of their ‘educators’) is the topic of high volume trading. When discussing HFTs it is crucial to understand how volume affects profitability. One of the benefits of higher frequency styles of trading is that the trader or firm will receive significant discounts on commissions.
Source CME
The tables above are taken from the CME website and relate to the fees and discounts for high volume traders. In the top image we see that those who trade over 135,000 contracts of ES per day receive a discount of 0.25c per trade. In the bottom image the highlighted areas show us that for the ES, an equity member of the CME will pay 0.37c per side while a non-equity member will pay 0.62c per side. This is before the discount. Other fees may add up to around 0.10c.
So an HFT trading ES will pay around $1 a round trip (both sides) if it is not an equity member of the CME or as little as around 0.50c a round trip if it is an equity member.
With that information let’s do some math:
The dollar amounts in this table is per 100 trades for 1 lot.
What we can see in the table above is that even with just 30% profitable trades both equity and non equity member HFTs would be profitable overall if they achieve a 50% scratch rate. With these firms doing potentially hundreds of thousands of trades per day, millions per month and you can see how the profit adds up.
But in reality they can probably achieve win rates closer to 50% or just above.
As well as showing you the profitability attached to high frequency trading, a major point that I want to get across is that HFTs don’t necessarily have to have high win rates.
So, why should we fear traders who may be winning on 50% or even fewer of their trades? We shouldn’t.
Be informed and keep grinding
What we hope to have shown is that HFTs are playing a different game and that manual futures day traders need not fear them. We should work out our edge, stick to it and keep grinding.
I’d like to thank Rob from Discovery Trading Group for his substantial input into this article. Rob is one of the most knowledgeable futures traders going around so make sure you check him out on Twitter.
Keep Grinding
Gary