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What Is High-Frequency Trading (HFT) and How Does It Work?

What Is High-Frequency Trading (HFT)?

What Is High-Frequency Trading (HFT) and How Does It Work?

HFT, or high-frequency trading, is a method of trading in which powerful computer algorithms execute a large number of orders in fractions of a second. It analyses many marketplaces and uses complex algorithms to execute orders based on market conditions. Traders who execute orders swiftly often outperform those who execute them slowly.

HFT is defined by high turnover rates and order-to-trade ratios, in addition to the rapid speed of orders. Tower Research, Citadel LLC, and Virtu Financial are some of the most well-known HFT firms.

  • HFT (high-frequency trading) is a type of algorithmic trading in which a huge number of orders are completed in a matter of seconds.
  • It increases market liquidity and eliminates tiny bid-ask spreads.
  • HFT has been chastised for allowing major corporations to obtain a trading advantage.
  • Another criticism is that the liquidity generated by this sort of trading is transient—it vanishes in a matter of seconds, making it impossible for traders to profit from it.

» Learn more: Read our explainer on Best Times of the Day to Buy and Sell Stocks in 2022

High-Frequency Trading: What You Need to Know (HFT)

HFT became popular when exchanges began to provide incentives for firms to contribute liquidity to the market. For example, the New York Stock Exchange (NYSE) has a network of liquidity providers known as Supplemental Liquidity Providers (SLPs) whose goal is to boost competition and liquidity for existing quotes on the exchange.

Following the fall of Lehman Brothers in 2008, when investors were concerned about liquidity, the SLP was created. The NYSE pays a charge or a rebate to corporations in exchange for providing liquidity. With millions of transactions every day, this generates a sizable profit margin.

High-Frequency Trading's Advantages (HFT)

HFT has increased market liquidity and reduced bid-ask spreads that were previously too narrow. Fees on HFT were added to test this, causing bid-ask spreads to widen.

One research looked at how Canadian bid-ask spreads altered when the government imposed fines on high-frequency trading. It was shown that market-wide bid-ask spreads grew by 13%, while retail spreads climbed by 9%.

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High-frequency trading has been criticised (HFT)

HFT is a contentious topic that has drawn a lot of criticism. It has replaced a number of broker-dealers and makes choices using mathematical models and algorithms, eliminating the need for human decision-making and interaction.

Decisions are made in milliseconds, which could lead to irrational market movements. For example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) saw its greatest intraday point decline in history, plummeting 1,000 points and 10% in just 20 minutes before rebounding again. The crash was blamed on a huge order that caused a sell-off, according to a government probe.

Another criticism of high-frequency trading is that it allows giant corporations to profit at the expense of the "little guys." Its "ghost liquidity" is also a source of criticism: HFT-provided liquidity is available to the market one second and gone the next, preventing traders from actually trading it.

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Don't forget to read: What is a Spread in Forex Trading?


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