What Is High-Frequency Trading & How Does It Actually Work?

High-frequency trading is a method that uses powerful computer programs to transact a large number of orders in approximately one 64 millionth of a second.

The rush for speed to profit from the friction of the second movement gained significant traction this century, with estimates showing that High-Frequency Trading currently accounts for almost half of the overall stock trading volume in the United States.

Here’s how it works. Let’s say if you believe the price of any stock is likely to rise or fall for a second or a microsecond, and you want to make profits from that price movement. For that, you need to make and execute a decision in a split second before that movement occurs. Once you are able to buy shares a split second before the price rises and then sell afterward, you are likely to make profits in seconds with minimal risk due to speed.

Once upon a time, the stock exchange was a physical place where humans would go and trade with one another. But today everything is automated and done by the equivalent of Moore’s law.

“That means trading decisions are much faster than any human could ever possibly be. Even a few microseconds slower or faster can make a big difference for a trader,” said Joshua Mollner, Kellogg's Associate Professor of Managerial Economics & Decision Sciences.

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If you’re interested in a white paper on how high-frequency trading works, we’d defer you to this academic paper by the University of Oxford about the accuracy and predictability of signals that are beyond the scope of this post.

High-frequency trading, also known as algo trading, mostly belongs to institutional investors who use specialized algorithms to detect price movement.

These complex computer-powered algorithms have the potential to detect the small price movement at lightning speed — well before humans can identify them. This technology is usually employed by sizable financial institutions and hedge funds due to the involvement of large blocks trading.

Using ultra-high-speed computer programs in high-frequency trading is key to generate, route, and execute orders.

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HFT firms generally stay under the radar by using their own money, infrastructure, and strategies to generate profits. There are three types of HFT firms:

✅ Most HFTs are independent proprietary firms — these firms use their own money for high-frequency trading.

✅ Some broker-dealers also set up a separate HFT unit known as proprietary trading desks.

✅ Hedge funds also operate as HFT firms to make money.

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HFT firms are making money using different strategies, but all of these strategies revolve around high-power computers along with algorithms and software. Market making, statistical arbitrage, and latency arbitrage are among the most common strategies.

Market Making: HFT firms act as market-maker to make profits. This is done by placing orders from both sides. For instance, to earn profit from the bid-ask spread, the firm places both a limit offer to sell and a limit order to buy. HFT firms that act as market makers and provide liquidity to exchanges also get paid for every trade, known as a rebate.

Statistical arbitrage: This strategy involves making money by searching for price discrepancies between asset classes or different exchanges. As these price discrepancies are very short-term and temporary, HFTs use high-powered computers and software to make a profit from discrepancies. Event arbitrage is also among the most common strategies HFTs are using for profit generation.

Latency arbitrage: Institutional investors and HFT firms employ latency arbitrage strategies to capitalize on the price differences in stock due to the time disparity between traders and other participants. These time disparities occur due to several reasons, including infrastructure, slower computers, and internet connection. In order to reduce latency, HFT firms acquire extremely fast infrastructure to access stock prices before retail traders.

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Despite the fact that HFTs represent more than half of the overall trading volume in the US, making profits through speed is among the most controversial topics over the last two decades. Below are the few concerns that make HFT controversial:

  • The creation of ghost liquidity is one of the major criticisms over HFTs trading practices. Critics say liquidity creation from HFTs lives only for a few seconds because securities are held for seconds.
  • Another concern is that HFT gives institutional investors an upper hand over retail investors. This is because high-frequency traders have the opportunity to trade security several times before a regular investor can initiate a trade.
  • The use of algorithms and high-power computers could also create uncertainty in securities prices. Algorithms can also create artificial price movement by canceling thousands of orders just after initiating them.
  • Fierce competition among HFTs may have adverse effects on market liquidity, according to various studies.
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Critics blame high-frequency trading for the flash crash that occurred in May 2010. On May 6, the major indices crashed dramatically for a few minutes and then bounced back rapidly.

In the aftermath of the trillion-dollar crash, the joint report from regulators stated that the sequence of events led to the flash crash and high-frequency traders contributed to that volatility.

The report identified a very large single sale trade of $4.1 billion in the S&P e-mini futures contracts by a mutual fund for increased volatility.

To avoid sudden and unrealistic price movements, the SEC came up with a new circuit breaker rule. According to the new rule, trading of any stock pauses when it moves up or down by 10% or more in a five-minute period.

The regulators said, “Market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets during the flash crash.”

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Although several studies are criticizing high-frequency trading and algorithmic trading, others show that market-making in high-frequency trading helps in lowering the volatility and costs for retail investors, adding that HFT also does not threaten the entire system and does not impact long term investors.

“I don’t think you necessarily have to counter that high-frequency trading is predatory because it’s not,” Peter Nabicht of Modern Markets Initiative said. “High-frequency trading is simply a tool, a tool used by a wide variety of participants in the market for a wide variety of reasons. It’s how they transact:

While the HFT helps investors generating massive returns within seconds, the fast trading system also has a positive impact on the overall market. Below are a few benefits of HFT on the overall market:

  • High-frequency trading significantly slashed bid-ask spreads, which helps in creating more efficient markets.
  • The creation of liquidity is one of the biggest benefits of HFT in its advocates’ view.
  • HFTs help retail traders to avoid trade commissions, and the competition to fill trade orders yields a better price.

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