When it comes to your investments, what can you do with a few milliseconds?
If you’re a normal person handling your retirement portfolio, the answer is easy: nothing. If you’ve got a Wall Street computer equipped with powerful algorithms designed for high-frequency trading, you could earn—or lose—millions.
High-frequency trading, or H.F.T., first hit the stock markets in the 1980s. Computer algorithms make it possible to spot market trends almost as quickly as they appear, and then rapidly trade shares made available by slower investors. Thanks to these increasingly powerful algorithms, high-frequency trading will likely earn around $1.25 billion in profits this year.
But as we all know, computers can be glitch-y. In August of this year, Knight Capital, a trading firm that had built its reputation on its H.F.T. prowess, accidentally lost $440 million in stocks over a single morning, thanks to a malfunction in newly installed software. Earlier this week, two bids were made by other H.F.T. firms Getco and Virtu to take over Knight, which has been struggling since the summer scandal.
Due to events like this, regulators are starting to turn a critical eye toward high-frequency traders. Is high-frequency trading merely a lucrative trend that will soon fade away due to stabilizing markets? Are these super-computers putting normal investors at a disadvantage—or actually helping them?
We’ll take a closer look at what you need to know about high-frequency trading, and what kind of regulations—if any—should be put into place to protect your portfolio.
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How Exactly Does High-Frequency Trading Work?
Tech-savvy Wall Street firms have developed algorithms so powerful that they can scan dozens of public and private markets simultaneously in order to identify trends and place millions of orders per second. And since these computers process information much more rapidly than a human investor, they can change orders and trading strategies within milliseconds.
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A normal investor might research a company, become confident in its long-term prospects, purchase shares and then hope to sell them at a profit some years down the road. In contrast, the algorithms used in high-frequency trading firms can spot tiny price differences, and act quickly to benefit from them. For instance, the algorithms might notice that a stock is being sold on one exchange for one cent less than on another exchange. High-frequency trading algorithms could buy and sell millions of these shares almost instantaneously, turning a huge profit before a human might even notice the price difference.
High-frequency trading is most potent in a declining or volatile marketplace because these traders seize on the stocks offered for sale by slower investors. The years 2008 and 2009 were booming for high-frequency traders, but climbing indexes in the last couple of years have hurt firms that rely on high-speed trading. Additionally, the cost of producing new algorithms to increase trading speed by fractions of a second has hurt firms’ bottom lines.