High Frequency Trading (HFT) is when a trader or institutions utilizes technology and powerful computers to automate trading and execute large orders at very high speeds through the use of algorithms.
Their super computers are able to scan the stock market in seconds looking for ideal trading scenarios which gives them a big advantage over retail traders who don’t have the resources or capital to trade like this.
Since speed is vital to getting the best execution price possible, these super computers are making their owners more money than traders with slower computers.
How High Frequency Trading Works
Traders who utilize high frequency trading build algorithms that analyze stocks and price patterns much more quickly than any person can, giving them an edge in spotting new market trends.
Usually High Frequency Trading aren’t looking to make one big trade but rather make a lot of little ones sometimes only looking to scalp a couple of cents between the bid and ask prices, which doesn’t sound like a lot but when you’re doing millions of trades a day it adds up to a lot of money.
High Frequency Trading became popular after exchanges started to offer incentives to provide liquidity in the markets, which would then earn them fractions of a penny per share for providing the liquidity, known as a rebate.
So for instance, if you are placing orders to buy at the bid or lower and are executed on the trade, you are providing liquidity in the markets where if you placed a market order to buy you would be taking liquidity out of the market and wouldn’t receive the rebate.
The Good & The Bad
High Frequency Trading has been both a good and bad thing because now there is plenty of liquidity in the markets, but it has been viewed as an unfair advantage for large firms who have the resources to take action more quickly.
Small retail traders can be subject to large market moves for no reason because a computer had a glitch, which is what happened in the May of 2010 when the DJIA dropped over a 1,000 points in just 20 minutes.
However, a large benefit that some people fail to understand is that before High Frequency Trading existed, the cost of trading stocks was much higher and spreads were generally a lot larger. They have provided a ton of liquidity in the markets and made it cheaper for retail traders to place trades and participate in the markets.