What Is High-Frequency Trading (HFT)? How It Works and Example

What Is High-Frequency Trading (HFT)?

High-frequency trading, also known as HFT, is a method of trading that uses powerful computer programs to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds.

In addition to the high speed of orders, HFT is also characterized by high turnover rates and order-to-trade ratios. Some of the best-known HFT firms include Tower Research, Citadel LLC, and Virtu Financial.

Key Takeaways

  • HFT is complex algorithmic trading in which large numbers of orders are executed within seconds.
  • It adds liquidity to the markets and eliminates small bid-ask spreads.
  • HFT is criticized for allowing large companies to gain an upper hand in trading.
  • Another complaint is that the liquidity produced by this type of trading is momentary—it disappears within seconds, making it impossible for traders to take advantage of it.

Understanding High-Frequency Trading (HFT)

HFT became popular when exchanges started to offer incentives for companies to add liquidity to the market. For instance, the New York Stock Exchange (NYSE) has a group of liquidity providers called Supplemental Liquidity Providers (SLPs) that attempts to add competition and liquidity for existing quotes on the exchange.

The SLP was introduced following the collapse of Lehman Brothers in 2008, when liquidity was a major concern for investors. As an incentive to companies, the NYSE pays a fee or rebate for providing said liquidity. With millions of transactions per day, this results in a large amount of profits.

Benefits of High-Frequency Trading (HFT)

HFT has improved market liquidity and removed bid-ask spreads that previously would have been too small. This was tested by adding fees on HFT, which led bid-ask spreads to increase. One study assessed how Canadian bid-ask spreads changed when the government introduced fees on HFT. It found that market-wide bid-ask spreads increased by 13% and the retail spreads increased by 9%.

Critiques of High-Frequency Trading (HFT)

HFT is controversial and has been met with some harsh criticism. It has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, taking human decision and interaction out of the equation.

Decisions happen in milliseconds, and this could result in big market moves without reason. As an example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) suffered its largest intraday point drop ever, declining 1,000 points and dropping 10% in just 20 minutes before rising again. A government investigation blamed a massive order that triggered a sell-off for the crash.

An additional critique of HFT is it allows large companies to profit at the expense of the "little guys." Its "ghost liquidity" is also a source of criticism: the liquidity provided by HFT is available to the market one second and gone the next, preventing traders from actually being able to trade this liquidity.

Article Sources
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  1. New York Stock Exchange. "Liquidity Programs." Accessed Aug. 25, 2021.

  2. New York Stock Exchange. "Transaction Fees." Accessed Aug. 25, 2021.

  3. Katya Malinova, Andreas Park, and Ryan Riordan. “Do Retail Investors Suffer from High Frequency Traders?” January 11, 2018, SSRN. Accessed Aug. 25, 2021.

  4. U.S. Securities and Exchange Commission. "Testimony Concerning the Severe Market Disruption on May 6, 2010." Accessed Aug. 25, 2021.

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