High frequency trading continues to grow and influence the day-to-day movements in the markets. What is high frequency trading and why should all investors care about it? 

What Is High Frequency Trading?

High frequency trading refers to automated trading platforms used by large institutional investors, investment banks, hedge funds and others. These computerized trading platforms have the capability to execute a large volume of trades at very high speeds.

The SEC doesn't have a formal definition of high frequency trading, but they attributed these five characteristics to high frequency trading in a study several years ago:

  1. Use of extraordinarily high speed and sophisticated programs for generating, routing, and executing orders.
  2. Use of co-location services and individual data feeds offered by exchanges and others to minimize network and other latencies.
  3. Very short time frames for establishing and liquidating positions.
  4. Submission of numerous orders that are canceled shortly after submission.
  5. Ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight).

 There is no set definition of high frequency trading, but the SEC criteria listed above provides a solid framework to understand how it works.

After the "flash crash" in May of 2010 when the markets dropped 10% in a matter of minutes, the SEC instituted circuit breakers when an index like the S&P 500 falls by certain levels during the trading day. The "flash crash" was widely attributed to institutions using high frequency trading programs. 

How Does High Frequency Trading Work?

The computers used to execute these trading systems are programed to use complex algorithms to analyze a large number of stocks across various exchanges. These algorithms are programed to spot trends and other trading triggers. Based on these results, these trading programs send out a high volume of stock trades to the market at lightning speed. The goal is to get out in front of the emerging trends spotted by the computers to give the institutions behind them an edge in the marketplace. 

When a large institution, like a pension fund or a mutual fund, buys or sells a large position in a particular stock the price of the stock generally moves a bit up or down after the trade. The computer algorithms used by high frequency traders are programmed to find these price anomalies and to trade on the other side of it. For example, a large sale of a stock might drive the price down, the algorithms would "buy on the dip" and then quickly sell their position at a profit when the stock's price snaps back to normal. 

In the normal course of business during the trading day, large institutional trade orders can also cause blips in the price of a stock. These are normal orders for these institutions but given the size of the orders they can cause the price to move up or down more than might be expected. The high frequency trader's algorithms are programmed to spot these price anomalies, make the appropriate trade (buy the shares or sell short) and then close out the position when the price moves back to a more normal level. 

What Are the Benefits of High Frequency Trading?

Many experts feel that high frequency trading programs actually hurt the small retail investor. They claim that these trading programs can cause sharp movements in the market as a whole, and in the price of individual stocks based on the momentum caused by these trading programs. 

The main beneficiaries of these programs seem to be the institutions using them and the clients they serve. 

High frequency trading is controversial and there are varying opinions on whether it is beneficial or harmful. Many say that the advent of high frequency trading has enhanced the market's liquidity and helped to narrow the bid-ask spreads on a number of stocks. Efforts to add fees to high frequency trading activities resulted in larger bid-ask spreads, so there is something to this. 

The narrowing of bid-ask spreads is mostly a factor on large cap stocks. This also impacts many ETFs, making trades in these vehicles more efficient as well. 

Risks of High Frequency Trading 

There are a number of potential risks from high frequency trading, including: 

  • Amplification of market risk. The algorithms that trigger high frequency trades can serve to exacerbate trends that market is already experiencing. If the market's momentum is already moving down, the triggering of a large number of high frequency trades can exaggerate these trends leading to a larger downturn than might have occurred without these trades.
  • The potential for ripple effects on other markets. Given the close interaction between world stock markets and other sectors of the economy, something that impacts one market can trigger high frequency trades in another market causing a domino effect across various stock markets, differing asset classes and the U.S. and world economies as a whole.
  • Added uncertainty among investors. High frequency trading algorithms can be triggered for reasons that ordinary investors might not consider when making investments. The uncertainty that their best analysis might be overridden by a computer algorithm adds a degree of uncertainty to the markets.
  • Faulty algorithms. The algorithms are computer programs written by human beings. While these are generally done by very smart people, the human factor does leave room for errors. The possibility of one of these imperfections in the programming of the algorithm triggering a major market downturn is a risk. 

Key Takeaways 

There are several key things to remember about high frequency trading: 

  • High frequency trading is computerized trading based off of algorithms that execute a high volume of orders within seconds.
  • High frequency trading adds liquidity to the markets and can help narrow overall bid-ask spreads.
  • Critics say that high frequency trading provides large institutional players an unfair advantage as they are able to trade in large blocks due to the use of these algorithms. Some of these critics also blame high frequency trading for exaggerating downward market movements in situations like the "flash crash."
  • Unless the rules change, high frequency trading is probably here to stay, it will continue to be a factor in the markets on an ongoing basis.

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