High frequency trading is the implementation of online stock trading strategies noted for extremely quick holdings, to exploit short-term market inefficiencies.
These ultra-short-term positions can be in a wide range of investment categories: stocks, options, futures, currencies, exchange traded funds (ETFs), and virtually any other investment that can be traded electronically.
To execute high frequency trading, sophisticated computer algorithms analyze reams of market data to pinpoint obscure, intraday trading opportunities that may become apparent for only a fraction of a second, or perhaps for as long as several hours. High frequency trading relies on computers because human beings are unable to process and interpret the staggering amount of data required to devise these “micro-trades.”
High frequency traders typically don’t use a lot of leverage and liquidate their entire portfolios on a daily basis. At the end of the day, even fractions of a penny in profits can accrue quickly and generate substantial returns. Sometimes called churn and burn, this sort of trading ordinarily doesn’t use leverage or accumulate positions.
High frequency trading can come in several forms. The most common method involves arbitrage, which exploits historical and predictable—but temporary—deviations from stable statistical relationships among securities. A classic example is interest rate parity in the foreign exchange market, and with it the fluid relationships among domestic bond prices, foreign currency denominations, currency spot prices and forward contract prices of the currency.
High frequency traders compete with each other in terms of their alacrity in finding new, hidden opportunities. Seeking to seize a mere fraction of a penny per share or currency unit on every trade, high-frequency traders flit in and out of their short-term positions several times every day.
High frequency trading is extremely risky. Big returns racked up in a short amount of time also can lead, just as quickly, to big losses.
High frequency trading is only undertaken by the most sophisticated of traders—and those with considerable intestinal fortitude. Ordinary investors with long-term goals and who seek steady wealth building eschew the roller coaster ride of high frequency trading.