# Understanding High-Frequency Trading (HFT): Basics, Mechanics, and Example

![High-Frequency Trading (HFT): Using powerful computer programs to transact a large number of orders in fractions of a second.](https://www.investopedia.com/thmb/8rJmxa-sv5G84wJrbVK1nP0BK7E=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/high-frequency-trading.asp-final-88956b5664b34a51936e613a61219b25.png)

*— Sydney Saporito / Investopedia*

## What Is High-Frequency Trading (HFT)?

High-frequency trading (HFT) leverages advanced computer programs and sophisticated algorithms to execute vast numbers of orders in mere fractions of a second. These algorithms rapidly analyze numerous markets and respond to varying market conditions to execute trades efficiently. Having the fastest execution speeds allows traders and financial institutions to capitalize on minimal price discrepancies for higher profitability, which distinguishes HFT through elevated turnover rates and order-to-trade ratios.

### Key Takeaways

*   High-frequency trading (HFT) uses sophisticated computer programs to execute a vast number of trades in mere fractions of a second, offering significant advantages in speed and efficiency. 
*   HFT has improved market liquidity and narrowed bid-ask spreads, though its controversial nature raises concerns about market stability and fairness.
*   Famous HFT firms like Tower Research Capital and Virtu Financial leverage this technology to capitalize on arbitrage opportunities and rapid market movements.
*   Critics argue that HFT can result in significant market disruptions, as evidenced by the 2010 "Flash Crash," and that it offers large institutions an advantage over smaller traders.
*   HFT has extended into the cryptocurrency market, offering the same speed and efficiency benefits while also posing similar risks.

  

## The Mechanics of High-Frequency Trading Explained

High-frequency trading is a [type of algorithmic trading](https://www.investopedia.com/articles/investing/091615/world-high-frequency-algorithmic-trading.asp). Traders are able to use HFT when they analyze important data to make decisions and complete trades in a matter of a few seconds. HFT facilitates large volumes of trades in a short amount of time while keeping track of market movements and identifying [arbitrage](https://www.investopedia.com/terms/a/arbitrage.asp) opportunities.

Some of the key characteristics of high-frequency trading include:

*   Trading at high speeds
*   A large number of transactions executed
*   Short-term [investment horizons](https://www.investopedia.com/terms/t/timehorizon.asp)

Because of the complexities and intricacies involved with HFT, it isn't surprising that it is commonly used by banks, other financial institutions, and [institutional investors](https://www.investopedia.com/terms/i/institutionalinvestor.asp).

HFT gained popularity when exchanges offered incentives for companies to add market liquidity. For instance, the [New York Stock Exchange (NYSE)](https://www.investopedia.com/terms/n/nyse.asp) has a group of liquidity providers called [supplemental liquidity providers (SLPs](https://www.investopedia.com/terms/s/supplemental-liquidity-provider.asp)) that attempt to add competition and liquidity for existing quotes on the exchange.

The SLP was introduced following the [collapse of Lehman Brothers](https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp) in 2008, when [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) was a major concern for investors. As an incentive to companies, the NYSE pays a fee or rebate for providing said liquidity. Millions of daily transactions generate substantial profits.

> **Important**
>
> Some of the best-known HFT firms include Tower Research Capital, Citadel LLC, and Virtu Financial.

## Assessing the Pros and Cons of High-Frequency Trading

### Advantages

The main benefit of high-frequency trading is the speed and ease with which transactions can be executed. Banks and other traders are able to execute a large volume of trades in a short period of time—usually within seconds.

HFT has improved market liquidity and eliminated very small [bid-ask spreads](https://www.investopedia.com/terms/b/bid-askspread.asp). This was tested by adding fees on HFT, which led to an increase in bid-ask spreads. One study assessed how Canadian bid-ask spreads changed when the government introduced fees on HFT. It found that market-wide bid-ask spreads increased by 13% and retail spreads increased by 9%.

### Disadvantages

HFT is controversial and has been met with some harsh criticism. It has replaced a number of broker-dealers and uses mathematical models and algorithms to make decisions, taking [human decisions and interaction out of the equation](https://www.investopedia.com/articles/active-trading/081215/new-alternatives-highfrequency-trading.asp).

Decisions happen in milliseconds, and this could result in big market moves without reason. For example, on May 6, 2010, the [Dow Jones Industrial Average (DJIA)](https://www.investopedia.com/terms/d/djia.asp) experienced its largest intraday drop, falling 1,000 points and 10% in 20 minutes before recovering. A government investigation blamed a massive order that triggered a sell-off for the crash.

Another critique of HFT is that it benefits large companies often at the expense of smaller traders. Its so-called ghost liquidity is also a source of criticism: The liquidity provided by HFT is available to the market one second and gone the next, preventing traders from actually being able to trade this liquidity.

Pros

*   Large volume of transactions at once
    
*   Easy and speedy process
    
*   Improves market liquidity
    
*   Removes small bid-ask spreads
    

Cons

*   Removes human decision making and interaction
    
*   Speedy transactions could result in major market moves
    
*   Traders can’t trade liquidity
    

## How Does High-Frequency Trading Work?

High-frequency trading (HFT) uses algorithms to automate and identify trading opportunities. HFT is commonly used by banks, financial institutions, and institutional investors. It allows these entities to execute large batches of trades within a short period of time. Because everything is automated, trading becomes easy. HFT provides the market with liquidity. But it can result in major market moves and removes the human touch from the equation.

## Does the Cryptocurrency Market Use High-Frequency Trading?

Yes, high-frequency trading does occur in the [cryptocurrency](https://www.investopedia.com/terms/c/cryptocurrency.asp) market. It works the same way that HFT does in other markets. Using algorithms, it analyzes crypto data and facilitates a large volume of trades at once within a short period of time—usually within seconds.

## How Fast Is a High-Frequency Trade?

High-frequency trading is fast. It can be as fast as 10 milliseconds. In some cases, it can be even less to execute a large batch of trades.

## The Bottom Line

Advances in technology have helped many parts of the financial industry evolve, including the trading world. Computers and algorithms have made it easier to locate opportunities and make trading faster. High-frequency trading allows major trading entities to execute big orders very quickly.

Although it makes things easier, HFT (and other types of algorithmic trading) does come with drawbacks—notably the danger of causing major market moves, as it did in 2010, when the Dow suffered a large intraday drop.

> **Article Sources**
>
> 1.  New York Stock Exchange. “[Liquidity Programs](https://www.nyse.com/markets/liquidity-programs).”
>     
> 2.  New York Stock Exchange. “[Transaction Fees](https://www.nyse.com/publicdocs/nyse/markets/nyse/NYSE_Price_List.pdf).”
>     
> 3.  Katya Malinova, Andreas Park, and Ryan Riordan, via SSRN. “[Do Retail Investors Suffer from High Frequency Traders?](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2183806)”
>     
> 4.  U.S. Securities and Exchange Commission. “[Testimony Concerning the Severe Market Disruption on May 6, 2010](https://www.sec.gov/news/testimony/2010/ts051110mls.htm).”
>     
> 5.  Equedia Investment Research. “[How Fast Is High-Frequency Trading? Faster than You Think](https://www.equedia.com/how-fast-is-high-frequency-trading/).”