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High Frequency Trading: CNBC Explains

Daniel Mihailescu | AFP | Getty Images

Fast, faster and fastest is the way computers have made, and remade, our lives. There may be no better example of how fast things have become — and the possible danger speed can bring — than by looking at high frequency trading in the markets.

So what is high frequency trading and how does it work? CNBC explains.

What is high frequency trading?

High frequency trading, often called by its acronym HFT, is the use of sophisticated technological tools and computer algorithms to trade securities on a rapid basis — and the emphasis is on very rapid.

HFT uses specific trading strategies that are carried out by computers. Unlike regular investing, an investment position in HFT may be held only for seconds,or even fractions of a second, with the computer trading in and out of positions thousands of tens of thousands of times a day.

HF traders compete on a basis of speed with other high-frequency traders — not long-term investors who look for opportunities over a period of weeks, months ,or years and compete for consistent profits.

With this speed and reach for higher profits comes higher risk, as high frequency trading has been shown to have a measure of reward per unit of risk thousands of times higher than the traditional buy-and-hold strategies.

The success of high-frequency trading is largely driven by the ability to simultaneously process volumes of information — something ordinary human traders cannot do. And specific algorithms designed for use in HFT are closely guarded by their owners.

How does HFT work?

There are some basic theories behind HFT, one of which is called market making. Here, HFT traders through their computer program place limits on buy or sell orders for securities in order to counter — or beat — other incoming market orders. With a flick of a switch, they are able to execute the order faster than someone else.

Ticker tape trading:

Another way HFT works is gathering embedded market data, such as stock prices and the number of shares traded, called ticker tape trading. By observing a flow of quotes, high-frequency trading machines are capable of extracting information that has not yet crossed the news. They then use this information to place orders at a rapid pace.

Arbitrage:

Arbitrage is profiting from the difference in prices on the same security— stock or bond — that's traded in different markets. For instance, it's having a buy on a stock in one market while having a sell position on it in another. Certain events surrounding a security like a judicial ruling, a merger, or announcement of a new product can set off the firm's stock -- up or down. High-frequency traders quickly can move on the stock, by selling or buying, faster than someone else.

What are the downsides to HFT?

HFT has supporters who say it improves market liquidity and critics who say it destabilizes the financial markets.

Algorithmic and high-frequency trading were both found to have contributed to volatility in the May 6, 2010 Flash Crash, when high-frequency liquidity providers were found to have withdrawn from the market.

A July 2011 report by the International Organization of Securities Commissions, an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010."

An October 2012 study by the Chicago Federal Reserve found that "every exchange interviewed had experienced one or more errant algorithms" and recommended "limits on the number of orders that can be sent to an exchange within a specified period of time."

The question is whether high-frequency market makers should be subject to various kinds of regulations. Currently they are not.

There have been calls for for high frequency traders to face so-called kill switches that would shut down a broker dealer's trading over erroneous orders or technology glitches. But a trading expert said the measure may be too difficult to implement in practice.

How popular is HFT?

By 2010 high-frequency trading reportedly accounted for over 70 percent of equity trades in the U.S. and was rapidly growing in popularity in Europe and Asia. But things may have cooled off a bit. The percentage of stock trades handled by firms that specialize in HFT fell to about 51 percent in 2012, according to estimates from the brokerage firm Rosenblatt Securities.

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