What is High Frequency Trading?

High frequency trading, commonly referred to as HFT, is gaining more attention, thanks at least in part to Michael Lewis’ book “Flash Boys.” While many people may have become more familiar with the term, not all investors are clear on what high frequency trading actually is.

HFT generally employs the use of sophisticated computerized trading tools. HFT is designed to take advantage of proprietary trading strategies that allow traders with advanced technology and lightning fast computers to move in and out of positions in a matter of seconds.

These large institutional money managers, such as mutual, pension and hedge fund managers, who control millions of dollars, are the ones that control the ups and downs of the stock market. When these money managers move money they move a lot of it at once, buying and selling thousands of shares of stock, and it is this type of buying and selling that causes the price of a stock to swing wildly.

Imagine a particular stock isn’t doing very much, just sitting there with a stable price per share. There are a lot of small trades from individual private investors for a few hundred shares here and there, but nothing to significantly increase its price and the growth trend for the stock seems to be perfectly steady.

Now consider that the stock traders are not all small individual private investors, but large institutional money managers. The larger trades will cause brief, sometimes erratic, spikes in the price of the stock. It is during these spikes that high-frequency traders will attempt to profit from the price fluctuations resulting from the large institutional trades.

When an institutional money manager sells a million shares of stock the price drops. As the price drops high-frequency traders swoop in and buy the stock, hoping they will be able to sell the stock at a higher price when the stock returns to its normal price. However, HFT is not as simple as it sounds.

The wild swings in the price of a stock caused by the buying and selling by the institutional money managers generally don’t last very long, usually only a few seconds, requiring swift and fast action in order to make a profit. Unlike more traditional trading, where investors generally like to see profits of .50 cents or more per share, high-frequency traders buy and sell stock much more often, being satisfied with only a few pennies, or sometimes even a fraction of a penny, of profit per share. The only difference is that they buy a large number of shares so those few pennies add up fast.

As computer software programs become more sophisticated the interest and efficiency of high frequency trading will increase. This trend concerns many traders who see HFT as a threat to overall stock market stability, fearing more incidents like the “2:45 flash crash” of 2010.

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