Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

High Frequency Trading (HFT)

What it is:

High frequency trading (HFT) is a computerized trading strategy used to exploit fleeting market inefficiencies. These ultra-short-term positions can be in a wide range of assets: stocks, options, futures, currencies, exchange-traded funds (ETFs), and virtually any other asset that can be traded electronically.

How it works (Example):

To execute high frequency trading, sophisticated computer algorithms analyze reams of market data to pinpoint obscure, intraday trading opportunities that exist for only a fraction of a second. High frequency trading relies on computers because human beings are unable to process and interpret the staggering amount of data required to execute these "microtrades."

High frequency traders typically liquidate their entire portfolios on a daily basis. At the end of the day, even fractions of a penny in profits can accrue quickly over a large volume of trades. Sometimes called "churn and burn," this sort of trading ordinarily doesn't use leverage or accumulate positions. Seeking to seize a mere fraction of a penny per share or currency unit on every trade, high-frequency traders flit in and out of their short-term positions several times every day.

The most common method of HFT involves "arbitrage," which exploits predictable -- but temporary -- deviations from stable statistical relationships among securities. A classic example tries to take advantage of the fluid and ever-changing relationships among domestic bond prices, foreign currency denominations, currency spot prices, and forward contracts that make up the theory of "interest rate parity."

High frequency trading is extremely risky. Big returns racked up in a short amount of time also can lead, just as quickly, to big losses.

Why it Matters:

High frequency trading is only undertaken by extremely sophisticated traders with the mathematical background to program complex algorithms as well as the technological power to execute millions of trades in a matter of seconds.

There is considerable debate within the financial community as to whether HFT is good or bad for capital markets. Proponents of HFT say that it provides additional liquidity by increasing the volume of trades on any given day. Opponents suggest that high frequency trading can be used to manipulate prices, giving HFT firms the ability to make billions of dollars at other traders' expense.