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Making sense of high frequency trading

Making sense of high frequency trading

On any given day, more than a billion shares of stock will change hands on Wall Street, half of which are done via super fast computer programs which are designed to process as many as 1,000 trades per second.

For this installment of Investing 101, we take a look at so-called High Frequency Trading (often called “HFT”) to show you how it works, why it’s so controversial and what’s being done to try to regulate it.

Active vs. Hyperactive Investing

The financial sector has always been focused on speed. Since the earliest days of trading, investors who got information - and acted upon it - the fastest, have been able to capitalize upon it. Today that is truer than ever, and big financial firms regularly spend more on technology and programmers than they do on MBA’s, in hopes of gaining an edge over their competitors. 

At a time when virtually every transaction is already entered, executed, confirmed, settled and warehoused digitally, faster computers combined with better connectivity have made a super fast process, just that much faster.

To do so, programs (or “algorithms”) are created that automate the normal buy and sell process in ways that aren’t humanly possible. 

For example, these so-called “black boxes” can simultaneously scour dozens of different trading venues in hopes of finding, and taking advantage of, any discrepancy in pricing. When they find one, they pounce, and flood a targeted security with a stream of matched buy and sell orders that are less than a penny apart.

Hey -  You Can’t Cut The Line!

An orderly marketplace is one of the basic tenets of our markets, and processing transactions in the order in which they are received is critical to maintaining confidence, trust and fairness. And yet, because of their technological edge, high frequency traders are routinely able to cut the line, so to speak, and move in front of larger orders, affecting the price and costing the next guy in line money.

Because these trades are executed automatically, at lightening speed, between two computers, they are often blamed with manipulating and distorting markets. The so-called Flash Crash of 2010, when the Dow lost 1,000 points in a matter of seconds, is arguably the best known example, but smaller isolated examples occur almost daily.

A Hard Problem to Fix

To say that HFTs are frustrating to ordinary traders would be an understatement, but it’s gotten to the point where some big fund managers are simply by-passing traditional trading routes and directly negotiating large trades instead.

Related: 'Upstairs' and Off-Limits: Why the Fastest Growing Area of Trading Is Unfair

The problem is in trying to figure a workable speed limit for a highway that no one wants to see slowed down or dis-automated. 

Even so, regulators and market players here and abroad are currently trying to do just that, and are quick to warn that simply focusing on the sheer speed and number of trades, won’t fix the problem.

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