What Is High-Frequency Trading?
High-frequency trading (HFT) is a strategy that uses computers to conduct trades at very high speeds, taking advantage of price disparities over very short periods of time in financial markets with electronic trading.
Large amounts of securities can be bought and sold almost instantaneously via HFT. A $2 million automated trade at the start of stock market trading, for example, can take place in a fraction of a second.
How Does High-Frequency Trading Work?
A computer program can be automated, or algorithms can be used to make trades based on short-term price fluctuations at very high speeds. A hedge fund, for example, could instruct its computers to make trades as the stock market opens, placing millions of dollars in buy or sell transactions before other market participants can do so. Later in the day, it may sell or buy those same securities at small price differentials to make a profit.
In another example, an algorithm might seek out price differences in shares of a publicly traded company on different exchanges—buying stock at a cheaper price on one exchange and then selling the stock at a higher price on another.
Hedge funds with high-frequency trading capabilities have an edge over traditional money-management firms that instruct their traders to conduct buy and sell orders in the open market in real time. A hedge fund, for example, could instruct its engineers to write a computer program to buy or sell a basket of stocks that move below or above their 20-day moving averages or relative strength index.
A Brief History of High-Frequency Trading
The Nasdaq Stock Market started operations in 1971 and was the world's first electronic stock market, but it wouldn’t be until decades later that money-management firms would attempt to capitalize on high-speed trading, leading the Securities and Exchange Commission to implement new regulations to help modernize financial markets.
Advances in computers, technology, and algorithms have made high-frequency trading a dominant force in financial markets. The SEC estimates that high-frequency trading in U.S. equity markets makes up about 55% of trading by volume. HFT also accounts for the majority of trading in commodities and futures markets.
Which Hedge Funds Use High-Frequency Trading?
Some of the biggest hedge funds in the U.S. that manage tens of billions of dollars actively engage in high-frequency trading, including Renaissance Technologies, Two Sigma, Citadel, and Susquehanna International Group. These hedge funds typically use a quantitative analysis approach to investing. In other words, they base their investment strategies on stock price movements, volume, and related data.
What Are the Advantages of High-Frequency Trading?
High-frequency trading is supposed to make markets efficient by smoothing out prices, reducing the spread between bids and offers on securities. HFT also helps provide liquidity to the market by increasing trading volume.
What Are the Disadvantages of High-Frequency Trading?
High-frequency trading can also go wrong, leading to volatility in a market and causing investors to lose millions of dollars. On May 6, 2010, an erroneous sell order by a mutual fund sparked selling by hedge funds via high-frequency trading, and that sudden burst of selling activity sent the Dow Jones Industrial Average plunging by 9%. The event was known as the flash crash.
On August 1, 2012, Knight Capital Americas installed incorrect computer coding on its automated routing system for equity orders, which led to millions of orders and several billions of dollars worth of unwanted positions. The securities broker-dealer lost more than $460 million and was fined $12 million by the SEC.
