High-frequency Trading

At first glance, high-frequency trading seems like the most elusive and mysterious of Wall Street's newest strategies--that's probably the reason it's been deemed the scariest. High-frequency traders capitalize on tiny price gaps between stocks and exchanges that can exist for only a matter of microseconds--that's a millionth of a second--using algorithmic codes programmed to read and act upon market trends. Proponents argue that the practice provides additional liquidity to the market, and smoothes out price differentials between exchanges, according to Advanced Trading.

But this supposedly smooth strategy has already had some slip ups. According to Reuters, high-frequency trading may have contributed to the still unexplained plunge in the Seattle biotech Dendreon's shares back in late April, which fell 69 percent in less than two minutes. The phenomenal speed with which the market reacted suggests that a certain "algorithmic misfire" may have occurred, whereby one computer began selling based on a misinformed trend, prompting other HFTs and market makers to sell and sell until the stock assumed its virtual free-fall.

The fear regarding systemic risk not only has to do with the ability of HFT to massively amplify the market effects of one computer's error, as with the Dendreon drop-off, but with the fact that such errors are completely automated. In the case of high-frequency trading, human error actually plays a minimal role. Add in the fact that the practice accounts for more than half of the daily trade volume, and the potential danger becomes clear.

Related Articles:
So you want to get into HFT?
How HFT will grow
A new reporting facility for HFT firms?
How far will the SEC's review go?