Your Scalping and High Frequency Trading : Two Very Different Things

The other day I was talking with a somewhat new trader -just under a year of experience- about scalping techniques and my opinions about them. When I said that I didn’t know anybody who had achieved trading success in the long term (5 to 10 years) using such techniques he was very quick to point to me to the fact that many traders are indeed successful this way and that huge companies profit simply from “scalping”. He was talking to me about high frequency traders also known in the trading industry as “quants”.  After he finished talking to me about these companies I asked him – what do you think “quants” do ? – and the answer was that they do very fast scalping and use trading strategies that need to trade thousands of times per day.

This experience with this trader showed me that there is a general misconception about high frequency trading and scalping and that many traders attempt to develop scalping techniques in the hopes of imitating high frequency traders without ever realizing that both types of trading are absolutely different in what they attempt to do. First we need to understand what the general retail trader scalper does and then we need to compare this with what high frequency trading attempts to do. After we get an understanding of these two trading techniques and the scenarios in which they happen we will see why attempting to imitate “quants” in a retail environment using tools such as metatrader 4 is a waste of time and an exercise which in the long term will yield absolutely no positive results.

So what do retail traders want to do ? When a retail trader talks about scalping he or she is generally talking about the taking of positions that are exit in less than 10 minutes or which take a profit below 5 times the spread. This is what scalping is for retail traders. Note here that scalping does not involve trading frequency but it merely involves the entering and exiting of positions on extremely low profit targets. Of course the idea is to do this as frequently as possible,  “scalping” the market for very small profits everyday. The idea of retail traders is to develop a strategy that can do this profitably in the long term something that has several technical problems since these strategies are impossible to evaluate in long term simulations due to the fact that they are extremely dependent on live execution variables. However as you see here retail scalpers need to have a positive mathematical expectancy to be profitable and this is attempted with the use of a scalping trading strategy (which cannot be adequately evaluated in the long term).

The big boys know that such scalping strategies will ultimately fail in the long term since their profitability cannot be adequately evaluated and the short term nature of the market changes in an almost random way. High frequency traders and companies do not attempt to profit from such “scalping strategies” but from market inefficiencies that arise with a guaranteed positive mathematical expectancy. Such inefficiencies are called arbitrage opportunities and arise for merely milliseconds – or even shorter periods of time – as the price of different instruments that should give a certain value, give another. In forex trading triangular arbitrage is the most common form of this game in which positions are taken on three currency pairs when their exchange rate doesn’t synch correctly. For example when the EUR/USD – GBP/USD exchange rates to go from EUR to GBP are not equivalent to EUR/GBP. High frequency traders use direct connections to banks and extremely high speeds to get in and out of this positions with a profit. The opportunities exist but they last merely a thousandth of a second so being very fast will allow you to take this very small profit. When you do this thousands of times a day you have a high frequency trader.

So the two worlds are extremely different. On one hand you have retail traders attempting to profit from short term strategies without ever knowing if they do have a positive mathematical edge (because they cannot evaluate them accurately due to execution variables) and on the other hand you have high frequency traders who exploit market arbitrage opportunities that last for only fractions of second (or even a millisecond). It is evident now that both scenarios are absolutely and totally different, the first scenario doesn’t lead to success with certainty since the strategies used as subject to a very large variety of problems (besides the lack of knowledge about a true statistical edge you are also influenced by how your execution changes with time) while the other case is a “sure way” to profit since the arbitrage opportunities are guaranteed to bring you profits (provided you are fast enough !).

A retail trader can therefore not compare him or herself with a “quant” in a high frequency trading environment because not only are they attempting to do two completely different things but their tools and possibilities are absolutely different. High frequency trading operations have – as I mentioned before – direct connections, very fast execution and custom made trading solutions (often made in matlab) while retail traders have a very slow metatrader 4 platform running through a broker (even if its an ECN) with much higher trading commissions and an execution which is at least slower by a factor of 1000.

After analyzing all this it becomes obvious why high frequency trading operations are successful and why retail traders who attempt to use scalping systems are not in the longer term. The first crowd looks for a “sure thing” by tapping very short lived arbitrage opportunities while the second group “guesses” by using strategies that depend on execution and whose risk and profit characteristics cannot be judged accurately. Of course if you would like to learn more about the development of trading strategies and how you can gain a true education regarding automated trading please consider joining, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)

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