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high-frequency tradingHigh frequency trading (HFT) is controversial. Some investors say it lets people capitalize off of opportunities that may vanish quite quickly. Others say high frequency trading distorts the markets. Supporters of high frequency trades have rhetoric in their corner, but opponents have data. Here’s what they’re all talking about.

High Frequency Trading Explained

There is no formal definition of high frequency trading. Most commonly, it is the process of using computer programs running preset algorithms to make trades very quickly. High frequency traders typically make an enormous number of trades per day. Sometimes they buy and sell stocks several times per second, dealing in very high volumes at the same time.

Automation makes this possible, allowing traders to execute trades with the kind of speed and volume that a human cannot.

Some sources expand the definition of high frequency trading. These sources use it to refer to any investor trading quickly and in large volume over the trading day. This is less common. In accepted use, high frequency trading refers to automated trading using computer programs and artificial intelligence.

While, again, there is no legal definition of high frequency trading, the Securities and Exchange Commission (SEC) has set forth five trading characteristics common to this practice:

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

Why Engage In High Frequency Trading?

high-frequency tradingHigh frequency traders can conduct trades in approximately one 64 millionth of a second. This is roughly time it takes for a computer to process an order and send it out to another machine. Their automated systems allow them to scan markets for information and respond faster and than a human possibly could. They complete trades in the time it would take for a human brain to process the new data appearing on a screen (no less physically enter new trade commands into their system).

This creates many profitable advantages for the trader, but three stand out in particular:

Volume Trading

This system allows traders to profit off of a sheer number of trades that would be impractical or impossible for a manual trader. Through automation a high frequency trader can conduct enough trades in enough volume to profit off even the smallest differences of price.

Short Term Opportunities

High frequency trading allows the investor to capitalize on opportunities that only exist for a short moment in the stock market. It also lets them be first to take advantage of those opportunities before prices have a chance to respond.

For example, say that a major investment firm liquidates one of its portfolios. Involved in this trade is approximately 1 million shares of Company X’s stock. In this case, the price per share for Company X would likely decline for a short time while the market adjusted to the newly released stocks. This dip could last for minutes or even seconds; not long enough for most manual traders to take advantage of, but plenty of time for an algorithm to conduct numerous trades.

Arbitrage Opportunities

Arbitrage is when you take advantage of the same asset having two different prices. For example, say in Town A soda sells for $1 per bottle while in Town B soda sells for $1.10. This would present an arbitrage opportunity. You could buy soda in Town A, then travel to Town B and sell it for the elevated price.

In most real world trading situations arbitrage opportunities are difficult to come by. This is because the speed and reliability of global information networks means that most prices update in practically real time around the world.

However “practically” is the watchword. High frequency trading can allow investors to take advantage of arbitrage opportunities that last for fractions of a second. For example, say it takes 0.5 seconds for the New York market to update its prices to match those in London. For half of a second, euros will sell for more in New York than they do in London. This is more than enough time for a computer to buy millions of dollars’ worth of currency in one city and sell it for a profit in the other.

Benefits of High Frequency Trading

Beyond the benefits to the individual trader, many investors argue that high frequency trading promotes both liquidity and stability in the marketplace. In particular, advocates say, this is because high frequency trading can quickly connect buyers and sellers at the price each wants. (This is called the bid-ask-spread; essentially, the difference between how much a buyer wants to “bid” for an asset and how much the seller “asks” for it.)

Like all automated trading, high frequency traders build their algorithms around the trading positions they’d like to take. This means that as soon as an asset meets a trader’s bid price, they will buy and vice versa for sellers with pre-programmed ask prices. This prevents inefficiency, which happens if traders can’t connect.

For example, assume that Peter held Stock A and wanted to sell it for $10. Susan wants to buy Stock A for $10. If the two connect, the stock will trade for $10. This arguably reflects its most accurate market price. However if they can’t connect Peter will reduce his price in order to find a buyer, selling Stock A for $9.50, arguably less than its actual market value.

High frequency trading allows this process to happen more quickly, advocates say, letting buyers and sellers meet each other’s’ bid and ask prices far more often than they would otherwise.

Criticisms of High Frequency Trading

high-frequency tradingCritics argue that high frequency trading allows institutional investors (the kind who can afford this technology) to profit off of value that doesn’t exist.

For example, consider again our arbitrage case. The price of a euro is $1.10 in U.S. dollars. In London, trading pushes that price down to $1.08. Hypothetically say it takes 0.5 seconds for the market in New York to reflect that change, so for that half a second the price of a euro is two cents more expensive in New York than in London.

During that interval a high frequency trader could buy hundreds of millions of euros in London then sell them near-instantaneously in New York, making two cents off each one.

In this case the trader would have made millions of dollars off of no actual market value. This money would have been created purely off of software lag. Too, this trading would have an adverse impact on the market. Currency traders wouldn’t be blind to the sudden surge in activity around the euro and they would react, causing the market to move in response to a series of trades made purely based around millisecond arbitrage.

The Bottom Line

Supporters of high frequency trading say it allows markets to more quickly find stable, efficient values. This has particular value to the retail investor, they argue, who can’t sit at their computer ready to trade at all hours of the day.

According to others, high frequency trading distorts the markets. It allows investors to profit out of illusory price differences that don’t reflect real value. It can distort the market and increasingly lead to stock prices that reflect trading strategies more than corporate value.

Investment Tips

  • If you aren’t sure if high frequency trading is the right investment strategy for you, consider consulting a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that can help you achieve your financial goals, get started now.
  • High frequency trading is only one strategy that investors use to manage their portfolios. Learn more about how professionals approach the market through our article on trading strategies.
  • Day trading isn’t for everyone. But if you’re looking to move your money in and out of assets fast you’ll certainly need the right tools. Check out some of the best apps on the market for this hands-on approach to investing.

Photo credit: ©iStock.com/kasto80, ©iStock.com/Asia-Pacific Images Studio, ©iStock.com/NicoElNino

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