High Frequency Trading – The Hidden Dangers of Scalping & Day trading

Almost invariably, when people first discover Forex, they are drawn to high frequency trading.

It’s the hottest topic in most chat rooms and forums, and it’s promoted heavily by brokers (so it must be legitimate, right?)  Not to mention, it appeals to the adrenaline-addicted aspect of our own personalities.

Let’s be honest, it’s what we want to do because it’s fun, at least initially.  Traders are attracted to fast-paced systems because they want immediate gratification and believe that with the promise of lots of trading opportunities – comes the promise of getting rich quick.

If you’re thinking about taking on a high frequency trading system or have already been using this method of trading, do yourself a big favor and read this article.

I am going to tell you why I think that scalping/day trading or any other high frequency trading strategy is not only an extremely risky way to trade Forex (financially), but could also have serious negative side-effects on your health and happiness.

The intensity of these trading systems can turn you into a non-showering chart-staring vegetable; negatively impact your everyday life by encouraging you to neglect your other responsibilities such as holding a job where you actually do earn money, or spending time with your spouse and children; and it can be especially dangerous psychologically, because if you blew your savings trying to get rich off of a ‘sure thing’, it may even have you contemplating suicide.

 

The Attraction of High Frequency Trading

The whole idea of high frequency trading is to open positions for only a very short amount of time, sometimes just a few seconds. This intense in-and-out trading is the ‘excitement’ fresh new traders are looking for.

Even if they are only lucky enough to walk away with breadcrumbs, it’s still a hell of a thrill ride. You can remember when you first started trading, right?  All you wanted to do was sit in front of the charts all day and take as many trades as you could.  Consider this:  How much analysis and thought could you possibly have been putting into your trade decisions?

Were you recording your trades in a journal where you could reflect on and analyze your wins and your losses?  Were you using a stop loss?  Were you careful to not overexpose yourself by taking several trades at once?  If you answered negatively to these questions, you are participating in risky behavior.

We’ve all been there at some point, but eventually the initial buzz wears off. The trader starts getting more serious and begins to focus greatly on actually earning money.

Unfortunately the trader is still ‘conditioned’ to that high frequency trading mentality. It can be a vicious cycle to break free from because no one likes to admit defeat, no one wants to accept that what they have been doing isn’t working.

Sooner or later, traders engaging in high frequency trading strategies will realize they’re flogging a dead horse.  The truth is that the high frequency trading approach to the market just doesn’t work.

 

Trader Burnout

High frequency trading, particularly scalping, requires you to spend many hours glued to monitors tracking the minute by minute movement.

If you go for a toilet break, or the kitchen to grab a coffee/something to eat, you may miss out on the trading opportunity you’ve been staring at the charts for the last 3 hours waiting for.  #frustrating

Sitting in front of the charts for too long is mentally taxing and will even affect you physically.

Personally, I’ve had enough after looking at charts for more than 30 minutes. The thought of spending extended amounts of time in front of them, keeping track of minute price-movements non-stop, makes me uneasy.

Your mind can only take so much. How long can you sit in front of charts and remain mentally focused?

How long before you get tired and start making bad trading decisions? What is the threshold where boredom kicks in and you start forcing trades just to make something happen? Trades should only be opened when the probabilities are in your favor, not because you need mental stimulation.

 

Small Room for Error

High frequency trading systems generally have very small profit targets.  Making decent returns for the day requires the high frequency trader to accumulate a disturbing amount of profitable trades to ensure their efforts are worth it.

Most high frequency trading systems encourage bad money management by exposing their account to an unhealthy amount of risk.  Generally, a high frequency trading system requires you to risk too much for the small gains. The risk reward ratios are usually in the negative, a serious red flag in my books.

In fact, the losses are so much bigger than the wins that one losing trade can put you in a deep hole that’s very hard to climb out of.

For example, a high frequency trader might risk twenty pips to gain five pips. That’s a negative risk/reward ratio of 4:1. To put that in perspective, one losing trade will set a scalper back four risk-factors.

The scalper’s next four trades will need to be successful in order to get the account back to the ‘break even’ stage.

Of course, that’s assuming the same lot sizing is being used on all the trades. High frequency traders also tend to use irregular money management, probably due to the fact that decisions are made quickly and ‘on the fly’.

High frequency trading can go pear-shaped fast, it’s frightening. For one, the chances of your next four trades being successful are against you. The margin of error allowed in this example is only twenty pips.

That’s not much at all considering that the average day-to-day market volatility is three times greater than that.  The market only needs to hiccup in the wrong direction and the trade is stopped-out. While the high frequency trader is trying to recover from losses, every single stop-out makes the hole, four risk-factors deeper.

To make a negative risk/reward system work, you must amass an overwhelming amount of winning trades over losing trades. Suffering a loss at any time is a huge setback.

The desperation and pressure builds immensely when high frequency trading strategies push accounts ‘into the red’. This starts to induce stress which grows into irrational and emotional Forex trading mistakes.

No high frequency trading system (or any trading system, in my opinion) is going to work in the long run unless the risk/reward ratios are in the positive.

If you’re risking twenty pips, then you should be aiming for at least forty pips in returns, not five. A positive risk/reward model of 1:2 allows you to lose half of your trades, but still make money in the long term. That’s why we are adamant about using positive risk/reward in our price action trading because you can’t win every trade, and no one expects you to.  It’s critical to ensure that your winners outperform your losers.

 

No Stop loss

Up to this point we’ve been assuming that high frequency trading strategies actually use a stop loss. I know most of them don’t, because the stops generally required are so tight that any tiny vibrations in the market will knock-out the trade.

These kinds of vibrations are the result of normal day-to-day activity in the market, such as when large commercial businesses perform overseas currency transactions that contribute to day-to-day volatility.

I’ve noticed most high frequency traders will blame these ‘abnormal’ intra day price movements on their broker trying to ‘stop hunt’ their trade.

So, to beat the market and their broker, they don’t set one.

We are huge believers of stop losses here at The War Room, we never place a trade without one. With no stop loss, your account is effectively 100% exposed.

I know most high frequency traders are running on the highest leverage possible for their account. One unexpected news release could drive their over-exposed account into a margin call.

Failing to use a stop loss is not smart trading; I can’t think of any real advantage of not using one. Your stop loss should be placed at the point which if price were to cross, the trade would be considered a failure and you should no longer be in the trade anyway.  

Having no stop loss means that you have to sit at the screen constantly monitoring your trade and decide when to manually close it. High frequency trading approaches also run the risk of getting caught up in re-quote errors when the market is experiencing increased volatility.  Have you ever tried to exit a trade during intense periods of volatility?

It’s not a position you want to put yourself in.  The bottom line is, sitting and staring at price charts all day/night is not a healthy behavior and is going to lead to anxiety issues, and not using a stop loss is just crazy!

 

High on Emotion

High frequency trading systems are very emotionally-fueled ventures and attract those looking for a massive adrenaline rush. Short-term traders can be so disconnected from discipline that many of their trading decisions are just based off of ‘gut-instinct’.

With each new position opened, there is a lot at stake for such minute profits. High frequency trading methods can put a high level of importance on each trade.  Traders become highly fixated to the success of one position.  Why? simply because the loss becomes too much of a hit to take.  I’ve seen high frequency traders who hold positions open at -100 pips; because they are waiting for the market to turn around and hit their 5 pip profit target.

When a losing trade is finally closed, guess what usually comes next?  The revenge trade.  This is often another bad trade involving the same pair (all while holding a grudge and believing that you’re going to ‘get your money back’).  This is the definition of losing your cool and trading emotionally, I see it all the time.  The constant chasing of price and running high on emotions, gives a trader the mind-set that they’re ‘fighting the markets’.

What is really happening is that they’re riding high on adrenaline and endorphins. Even when the trader is failing miserably, nothing else matters to them!  It’s like an addiction to drugs.  These guys know it’s detrimental to their wallet and their quality of life, but they still continue with the same behaviors and chase that rush.

It’s common knowledge that emotions and trading create quite a dangerous cocktail. You’re not doing yourself any favors by using a high frequency trading system that can easily amp up these emotions to destructive levels.  The market takes no prisoners.  When a trader breaks under pressure and shows their emotional cards, the market will exploit these emotions and play them against the trader.

 

Over Trading

High frequency trading is one of the most demanding of all the trading styles. Most traders are unhappy with the amount of money they are making compared with the unlimited money making money potential of the market. So, they believe they can remedy this problem by simply trading as much as they can. This is one of the driving forces behind the attraction to high frequency trading strategies.

Over trading is a massive problem for short-term traders. If they’re already opening and closing trades at high frequency, what’s another trade or two, what’s another twenty? This encourages the gambling mindset when the trader is no longer thinking probabilities, but trading purely from greed, boredom, desperation or overconfidence. Your attitude towards the market is going to define you as a trader. You think you’re chasing money, but in reality, the only thing you’re chasing is your own tail.

 

Analysis Paralysis

Most short term – high frequency trading system templates I’ve seen are quite heavy on the indicators. Quite a few of them actually require you to monitor multiple time frames at once. I know those images of multiple trading screens, flashing Forex indicators and rolling price feeds looks exciting to the new trader, but it’s far from practical when it comes to your trading performance.

More data or more analysis will NOT create more of an ‘edge’ for you in the markets. In fact, it will do quite the opposite. All the extra variables you bring onto your charts are only going to make it harder for you to execute clear-minded, logical trading decisions.

Frequently, your precious ‘chosen variables’ will conflict with one another, so even though you don’t realize it at the time – you’re creating your own trading nightmare by trying to incorporate all of these things into your analysis.

This is why we are such big fans of trading with price action on naked price charts. The clarity you get is unmatched by any other trading system, and that’s why it is the most successful trading methodology in this industry.

 

Conclusion

There is one winner out of all this, and that’s your broker. Brokers benefit from high frequency trading so greatly, that they will even pressure you to do it. Brokers earn spreads on each trade you place, regardless of whether it’s a winner or a loser.  So, yes they want you to be a high frequency trader.  They want us all to be high frequency traders!

The truly sad thing here is, the broker will sometimes earn twice the amount from a trade that the high frequency trader does.  Swing traders, like us War Room Traders, don’t have to worry about spread.  Even an expensive spread like 10 pips, is not going to affect a trade very much, when it has an expected return of 150 pips.

Despite what you read in the trading forums, high frequency trading does not by any definition offer the means to a smooth, risk-free path to greater profits. It’s very demanding mentally and physically, takes up large amounts of your time and can have a negative impact on your life.  In our article:  do 95% of traders lose money?, we show evidence that the majority of  losing traders are in fact the traders using high frequency trading strategies.

If you’re sick of being bombarded with the false promises that high frequency trading systems make, or maybe you just have real-life commitments, like a full time job, which wouldn’t allow you to engage in high frequency trading – you should take a serious look at our end of day trading strategies.  These swing trading strategies use price action and demand a fraction of the chart time per day.  In fact, you should be trading much less while generating larger returns and experiencing a far greater rate of success.

Before you start trading with real money make sure you check out our Forex trading checklist.  Also, remember:  scalping, day trading or any other high frequency strategy may appear as ‘smart investing’ in advertisements, but it’s only clever wording that is designed to target your emotions and encourage you to hand over your hard earned money.

I hope today’s article has highlighted the dangers of high frequency trading. If you enjoyed the article please help us spread the word and share the article using the buttons below. I wish you a profitable trading week.