What is High Frequency Trading, How it works!

Today around 73 percent of equity trading in the US is being carried out using high-frequency trading. High-frequency trading seems mysterious, and somewhat scary, particularly for beginner investors. The words ‘high frequency’ itself conjures an image of bespectacled individuals in gray suits sitting in front of a large computer screen and engaged in a trading frenzy.

But the reality is far from this.

High-frequency trading is not technically carried out by individuals. It is the machine that executes the trades in large volumes automatically using algorithms provided by the investors. In this article, we will take a close look at the trading technique that gaining increased popularity in the US.

How High-Frequency Trading Works?

High-frequency trading is a type of computer trading characterized by high order-to-trade ratio and high turnover rates. Also known by its acronym HFT, the trading is carried out using complicated computer algorithms on a rapid basis.

In layman terms, HFT simply refers to automated buying and selling of securities at lightening fast speeds. The trades are executed in thousands of seconds and in some cases millionth of a second. Apart from speed, some of the other salient characteristics of the trading activity include:

• Short Term: Traders hold positions for very short duration
• High Volume: Traders turn over the positions at least thousands of times in a day to make a profit
• Propriety Capital: Traders usually use their own capital instead of using leverage

HFT traders specify different rules to move in and out of positions. The aim is to profit from slight movement in the prices. Usually, a buy signal is specified when the price is below the trend while a sell signal is specified when the price is above the trend. The trades are executed within a fraction of a second whenever the algorithm is triggered.

What are the Pros and Cons of HFTs?

The biggest advantage of the HFTs is that the trading is driven by simultaneous processing of large volume of data – something that is not possible for an ordinary investor.

Another prime benefit of HFT is that the computer systems not only read the information of quotes and volumes but also peep into the order books at the exchanges to make the trade decision. The algorithms can also interpret news and take actions much before humans have a chance to react. This results in higher chances of making profitable trades.

Lastly, trading in large quantities of volume increases the profit earning potential for the trader. On the flip side, trading at high volume also increases the risk of loss. In fact, HFT has been shown to have a much higher risk-to-reward ratio as compared to traditional buy-and-hold strategy.

In the end, remember that HFT is a tool. The success of using HFT to make a trading decision depends on the trading rules that are specified by the trader. One should understand the fundamental and market forces relating to the underlying securities when using the tool to carry out the trades.