High-frequency trading is an advanced trading strategy that uses computer programs and algorithms to automate trading. Using the power of computer algorithms, high-frequency trading enables an investor to trade at a high frequency, often placing a large number of orders per second.
High-frequency trading allows an investor to profit from the short-term volatility of the stock market. Because of the programs needed for high-frequency trading, it’s a tactic frequently used by institutional investors.
Despite the potential benefits, high-frequency trading has some downsides, both for investors and the market in general.
How Does High-Frequency Trading Work?
There’s not necessarily a strict definition of high-frequency trading, but the Securities and Exchange (SEC) commission considers high-frequency trading to be any trading that has the following characteristics:
The use of extraordinarily high-speed and sophisticated programs for generating, routing, and executing orders
The use of co-location services and individual data feeds offered by exchanges and others to minimize network and other latencies
Very short time frames for establishing and liquidating positions
Submission of numerous orders that are canceled shortly after submission
Ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight)
The computer algorithms used in high-frequency trading can make millions of trades per day. They can quickly analyze different markets and identify potentially profitable investment opportunities. The goal is to find orders at bid-ask spreads that are advantageous to investors, allowing them to gain profits on as many trades as possible.
The goal of high-frequency trading isn’t to make large profits on trades. In fact, profits could be as low as cents per trade. And rather than holding securities and waiting for them to increase, High-frequency trading often involves buying and immediately selling an asset. But because of the sheer volume of trades that can be done throughout the day, those small profits can still add up to large overall returns.
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Is High-Frequency Trading a Good Idea?
High-frequency trading has several potential advantages. First, this trading tactic allows someone to trade a significantly larger volume of securities than would be possible without computer programs. Because of the large number of trades, investors have the potential to increase earnings, even if they have only small profits on each individual trade.
Another benefit of high-frequency trading — this one benefiting the entire market — is the liquidity it creates. Liquidity is important to individual investors because the more liquid an asset, the more quickly an investor can turn it into cash. High-frequency trading creates liquidity in the market by creating selling opportunities for securities holders. Similarly, high-frequency trading creates plenty of buying opportunities for investors who want to acquire a particular asset, since high-frequency-trading investors aren’t holding them for long periods.
That said, there are also downsides to high-frequency trading. First, some argue that high-frequency trading creates an imbalance, with institutional and high-net-worth investors and average investors on the other. After all, not just anyone has access to these trading tools.
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Another downside of high-frequency trading is the volatility it can create in the market. When there’s a large number of trades happening, it can quickly push the price of a security up or down. Unfortunately, these price fluctuations can negatively affect individual investors and create market instability, even though there’s no rhyme or reason behind them.
For most investors, a long-term approach to investing is likely the best fit. Personal Capital’s free financial dashboard offers a variety of tools that can help you on your investing journey, including a savings planner, investment checkup tool, fee analyzer, and more. Sign up for free today.
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Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. Compensation not to exceed $500. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC. Analysis is conducted at the time of publication and may change over time, please see each company’s website for updated information. As of June 2022.