What is High Frequency Trading?

How to Trade Stocks - What is High Frequency Trading?

High frequency trading, also called arbitrage trading or HFT, is a form of automated trading employed by professional institutional investors using powerful computers to carry out millions of orders on multiple stock markets in just a few seconds. This gives the institutions that use high frequency trading a significant advantage.

This method of stock trading is of course not for beginners ! The institutions that use it, however, can spot new trends in a fraction of a second. By anticipating these trends institutions that make use of high frequency trading can realize significant profits on their trades as a result of the bid-ask spread.

Although the spreads only provide a fraction of 1% profit per trade, high profits are nevertheless achievable due to the extremely high volume of trades involved.

High frequency trading is seen by many to offer large firms an unfair advantage over smaller institutions and ordinary investors. Basically what these institutions do is use their speed advantage to buy a stock before others notice that it is moving, then when the rest of the pack start buying and the price moves up further they sell the stock back at the higher price. This is of course what happens all the time in stock markets, the difference this time is that the whole transaction takes only a fraction of a millisecond. The gains are small but repeated millions or even billions of a times a day the profits add up. This is the beauty of high frequency trading. It may all sound rather mechanical and boring but when millions are at stake then you can see why people would want to do it.

Andrew M. Brooks at mutual fund and investment company T. Rowe Price, a says “we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”

It seems to me that it was ever thus, the guy who gets the information first has an advantage.

Tim Worstall at the Examiner says the real question should be not "what is high frequency trading?" but "what is the problem with high frequency trading?" to which, he argues, the answer is "nothing".

According to Worstall the problem is not high frequency trading, but "flash trading", and unfortunately even people who ought to know better confuse the two.

Flash trading allows a trader to get a "peek" at the orders of other traders. It is, says Worstall, this flash trading that is the problem as it allows "front-running" a form of insider knowledge that can give you an advantage and that ought to be illegal.

Flash trading, however, is not high frequency trading or arbitrage trading.

High speed trading is just another form of arbitrage (buying something cheap in one place and selling it for more in another place). With high speed trading the trades are carried out so fast that the actual physical proximity of the computers involved to the computers on the stock exchange is a factor. Firms with computers right next door to the stock exchange can trade faster than firms with computers further away.

You would think that the Securities and Exchange Commission would know the difference between high frequency trading and flash trading but apparently they don't as the ban they have proposed covers both high frequency and flash trading. Ah well it's nice to know that idiots can make money too, there's hope for me yet !