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High-Frequency Trading (HFT)

An algorithmic trading characterized by the high speed of trading, extremely large number of transactions and very short-term investment horizon

What is High-Frequency Trading?

High-frequency trading (HFT) is an algorithmic trading characterized by the high speed of trading, extremely large number of transactions and very short-term investment horizon. High-frequency trading leverages powerful computers to achieve the highest speed and larger number of transactions. Due to its complexity, HFT is mainly used by large institutional investors such as investment banks and hedge funds.

 

High-Frequency Trading

 

Advantages of High-Frequency Trading

High-frequency trading, along with the high-speed trading of large volumes of securities, allows traders to profit even from the small bid-ask spreads. Trading algorithms can scan multiple markets and exchanges; thus, the traders can find more opportunities to profit.

In addition, many proponents of HFT argue that it enhances liquidity in the market. HFT clearly increases the competition in the market as trades are executed faster, and the volume of the trades significantly grows. Subsequently, the bid-ask spread goes down. The bid-ask spread is the measure of the liquidity (the smaller the bid-ask spread – the higher is the liquidity).

 

Risks from High-Frequency Trading

High-frequency trading remains a controversial activity, and there is still no consensus about it among regulators, finance professionals, and scholars.

One major criticism against HFT is that it only creates ghost liquidity in the market. HFT opponents point out that the liquidity cannot be created because the securities are held only for a brief period, and before the regular investor can buy a security, it’s already been traded multiple times among high-frequency traders.

Furthermore, it is supposed that high-frequency traders (large financial institutions) profit at the expense of smaller players in the market (smaller financial institutions, individual investors).

Finally, HFT is related to market volatility and even market crashes. In the past, regulators caught some high-frequency traders engaging in illegal market manipulations such as spoofing and layering. On top of that, it was proven that HFT substantially contributed to the market volatility during the Flash Crash in 2010.

 

Related Readings

Thank you for reading this guide on high-frequency trading. To learn more about other trading methods, investing, and more, we highly recommend the additional free resources below:

  • Investing: A Beginner’s Guide
  • Momentum Investing
  • Primary Market
  • Trading Mechanisms

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