What Is High-Frequency Trading (HFT)?

High-frequency trading (HFT) is a trading method that uses powerful computer programs to transact a large number of orders in fractions of a second. HFT uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Traders with the fastest execution speeds are generally more profitable than those with slower execution speeds. HFT is also characterized by high turnover rates and order-to-trade ratios.

Understanding High-Frequency Trading (HFT)

High-frequency trading is a type of algorithmic trading. Traders are able to use HFT when they analyze important data to make decisions and complete trades in a matter of a few seconds. HFT facilitates large volumes of trades in a short amount of time while keeping track of market movements and identifying arbitrage opportunities.

Some of the key characteristics of high-frequency trading include:

• Trading at high speeds
• A large number of transactions executed
• Short-term investment horizons

Because of the complexities and intricacies involved with HFT, it isn't surprising that it is commonly used by banks, other financial institutions, and institutional investors.

It became popular when exchanges started to offer incentives for companies to add liquidity to the market. For instance, the New York Stock Exchange (NYSE) has a group of liquidity providers called supplemental liquidity providers (SLPs) that attempts to add competition and liquidity for existing quotes on the exchange.

The SLP was introduced following the collapse of Lehman Brothers in 2008 when liquidity was a major concern for investors. As an incentive to companies, the NYSE pays a fee or rebate for providing said liquidity. With millions of transactions per day, this results in a large amount of profits.

Advantages and Disadvantages of HFT

Advantages

The main benefit of high-frequency trading is the speed and ease with which transactions can be executed. Banks and other traders are able to execute a large volume of trades in a short period of time—usually within seconds.

HFT has improved market liquidity and removed bid-ask spreads that would have previously been too small. This was tested by adding fees on HFT, which led bid-ask spreads to increase. One study assessed how Canadian bid-ask spreads changed when the government introduced fees on HFT. It found that market-wide bid-ask spreads increased by 13% and the retail spreads increased by 9%.

Disadvantages

HFT is controversial and has been met with some harsh criticism. It has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, taking human decisions and interaction out of the equation.

Decisions happen in milliseconds, and this could result in big market moves without reason. As an example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) suffered its largest intraday point drop until then, declining 1,000 points and dropping 10% in just 20 minutes before rising again. A government investigation blamed a massive order that triggered a sell-off for the crash.

An additional critique of HFT is it allows large companies to profit at the expense of the little guys. Its so-called ghost liquidity is also a source of criticism: The liquidity provided by HFT is available to the market one second and gone the next, preventing traders from actually being able to trade this liquidity.

The Bottom Line

Advances in technology have helped many parts of the financial industry evolve, including the trading world. Computers and algorithms have made it easier to locate opportunities and make trading faster. High-frequency trading allows major trading entities to execute big orders very quickly. Although it makes things easier, HFT (and other types of algorithmic trading) does come with drawbacks—notably the danger of causing major market moves as it did in 2010 when the Dow suffered a large intraday drop.