What Is High-Frequency Trading?

Reviewed by Charles PottersFact checked by Vikki VelasquezReviewed by Charles PottersFact checked by Vikki Velasquez

High-frequency trading (HFT) is an automated trading platform that large investment banks, hedge funds, and institutional investors employ. It uses powerful computers to transact a large number of orders at extremely high speeds.

These high-frequency trading platforms allow traders to execute millions of orders and scan multiple markets and exchanges in a matter of seconds, thus giving institutions that use the platforms an advantage in the open market.

The systems use complex algorithms to analyze the markets and are able to spot emerging trends in a fraction of a second. By being able to recognize shifts in the marketplace, the trading systems send hundreds of baskets of stocks out into the marketplace at bid-ask spreads advantageous to the traders.

Key Takeaways

• High-frequency trading is an automated trading platform that large institutions use to transact many orders at high speeds.
• HFT systems use algorithms to analyze markets and spot emerging trends in a fraction of a second.
• Critics see high-frequency trading as an unfair advantage for large firms against smaller investors.

By essentially anticipating and beating the trends to the marketplace, institutions that implement high-frequency trading can gain favorable returns on trades they make by virtue of their bid-ask spread, resulting in significant profits.

Understanding High-Frequency Trading

The Securities and Exchange Commission (SEC) has no formal definition of HFT but attributes certain features to it:

1. Use of extraordinarily high speed and sophisticated programs for generating, routing, and executing orders
2. Use of co-location services and individual data feeds offered by exchanges and others to minimize network and other latencies
3. Very short time-frames for establishing and liquidating positions
4. Submission of numerous orders that are canceled shortly after submission
5. Ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight)

High-frequency trading became commonplace in the markets following the introduction of incentives offered by exchanges for institutions to add liquidity to the markets.

By offering small incentives to these market makers, exchanges gain added liquidity, and institutions that provide the liquidity also see increased profits on every trade they make, on top of their favorable spreads.

Although the spreads and incentives amount to a fraction of a cent per transaction, multiplying that by a large number of trades per day amounts to sizable profits for high-frequency traders.

Critics see high-frequency trading as unethical and as giving an unfair advantage for large firms against smaller institutions and investors. Stock markets are supposed to offer a fair and level playing field, which HFT arguably disrupts since the technology can be used for ultra-short-term strategies.

High-frequency traders earn their money on any imbalance between supply and demand, using arbitrage and speed to their advantage. Their trades are not based on fundamental research about the company or its growth prospects, but on opportunities to strike.

Though HFT doesn’t target anyone in particular, it can cause collateral damage to retail investors, as well as institutional investors like mutual funds that buy and sell in bulk.

Read the original article on Investopedia.