What is High-Frequency Trading?
High-frequency trading (HFT) is algorithmic trading characterized by high-speed trade execution, an extremely large number of transactions, and a very short-term investment horizon. High-frequency trading leverages special computers to achieve the highest speed of trade execution possible. HFT is very complex and, therefore, primarily a tool employed by large institutional investors such as investment banks and hedge funds.
Advantages of High-Frequency Trading
High-frequency trading, along with trading large volumes of securities, allows traders to profit from even very small price fluctuations. Trading algorithms can scan multiple markets and exchanges. This enables traders to find more trading opportunities, including arbitraging slight price differences for the same asset as traded on different exchanges.
Many proponents of HFT argue that it enhances liquidity in the market. HFT clearly increases competition in the market as trades are executed faster and the volume of trades significantly increases. The increased liquidity causes bid-ask spreads to decline, making the markets more price-efficient.
Risks of High-Frequency Trading
High-frequency trading remains a controversial activity and there is little consensus about it among regulators, finance professionals, and scholars.
One major criticism of HFT is that it only creates “ghost liquidity” in the market. HFT opponents point out that the liquidity created is not “real” because the securities are only held for a few seconds. Before a regular investor can buy the security, it’s already been traded multiple times among high-frequency traders. By the time the regular investor places an order, the massive liquidity created by HFT has largely ebbed away.
Furthermore, it is supposed that high-frequency traders (large financial institutions) often profit at the expense of smaller players in the market (smaller financial institutions, individual investors).
Finally, HFT has been linked to increased market volatility and even market crashes. Regulators have caught some high-frequency traders engaging in illegal market manipulations such as spoofing and layering. It was proven that HFT substantially contributed to the excessive market volatility exhibited during the Flash Crash in 2010.
Thank you for reading this CFI guide to HFT. To learn more about other trading methods, investing, and more, we highly recommend the additional free resources below: