Understanding High Frequency Trading

High frequency trading or HFT has become a big issue coming into the start of 2013. However, it is not entirely a new concept, but rather one brought about by technology and the need to profit from highly competitive markets. It is now important for most traders to know what this new trading strategy is and how it is increasingly affecting the different markets.

What is it?

High frequency trading or HFT is a term used to refer to a number of trading strategies that involve the buying and selling of different financial products at very high rates of speed and frequency. This type of trading strategy usually involves the use of computers and algorithms devised to identify minute changes and patterns in the market and institute buy and sell orders in a matter of milliseconds.

One way that HFT firms earn profits is when they take buying and selling positions in a market. With having both buy and sell sides, the high frequency trader is able to purchase at the bid price and sell at the ask price many times in a matter of seconds. This gives them the capacity to create trades that can number in the hundreds in just a day. High frequency traders are then able to earn penny profits on each trade. When multiplied over the millions of shares traded in a short span of time, this can translate into big profits.

HFT – Backed by technology.

Based on the extremely high speeds that HFT strategy conducts, it would not be possible if technology was not utilized to the fullest. Computers and special algorithms developed can monitor and keep track of market movements and trading activities in the market and act upon those small patterns that allow traders to profit even at the smallest possibility. But with computers and algorithms keeping a close watch on a market and designed to perform the action of buying and selling, there might be instances where the market conditions can be artificially manipulated, even if not on purpose.

Possible Effects and Consequences

The effects and consequences of high frequency trading are currently under debate. Some say that this strategy allows traders to find those small profit gaps and encourage market movement when conventional trading strategies see none. There is also this risk of high frequency trading influencing the market to create unnatural conditions that may greatly affect trading.

One cited instance of such a consequence happened sometime in 2010 where the Dow Jones Industrial Average suddenly plummeted around 10 percent in a matter of minutes. And just as quickly, it mysteriously rebounded. There was a time when some blue chip stocks traded briefly for a penny. The market regulators tagged the puzzling event to a very large trade that happened on the SP e-mini futures contract. This action resulted in a cascading effect that revolved around a group of high frequency traders. As one HFT firm sold rapidly, it triggered another to do the same based on the market pattern that its algorithms were able to pick up. As more selling action was felt, it triggered others to do the same thing, even the retail traders. This financial snowball effect was considered as a flash crash, a possible condition that high frequency trading may be able to cause.
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