High-Frequency Trading
High-frequency trading (HFT) is a strategy that uses algorithms and specialized trading systems to determine whether to buy or sell securities. The algorithms are mathematical formulas and computerized instruction sets that allow traders to execute a trade in a very short amount of time—we’re talking nanoseconds or a billionth of a second. Computers that are close to exchanges or ECNs have an advantage over computers that are farther away because information takes time to travel. For this reason, high-frequency traders try to get as close as possible to the rest of the market, sometimes by having their computers “co-located” in an exchange. In that vein, high-frequency traders are always seeking the best low latency. Low latency is a measure of the total time it takes for:
- • Information to reach a trader’s system
- • The algorithms to respond to the information
- • The order to reach an exchange and be implemented
High-frequency traders usually make tiny margins on each order, sometimes just a fraction of a cent. So by having their lightning fast systems close to the exchanges, high-frequency traders can have access to information and be able to take advantage of arbitrage opportunities faster than non-high-frequency traders. And because they may make millions of trades at a time, small margins can turn into big profits.
Proponents of HFT say that it provides more liquidity to the market, narrows bid-ask spreads, and lowers volatility. Researchers have found that the increase in HFT has lowered transaction costs for retail investors.
Critics of