Written by Daniel Cross. Updated by TraderHQ Staff.
The concept of capitalism and free-market trading has been around for centuries. Since the world’s first stock exchange opened in Amsterdam in 1602, investors have sought ever more inventive ways of trading assets and making profits. The Dutch East India Company popularized the idea of owning shares of a company, paving the way for transferable assets that blossomed into the modern financial world we live in today.
Background
Prior to the computer age, trading technology consisted of carrier pigeons followed by telegraph cables. The founder of Thomson Reuters, Julius Reuters, actually combined the use of pigeons and telegraph machines to build what became a state-of-the-art news agency that revolutionized the speed at which information regarding news events were disseminated to the public.
It wasn’t until the 1980s that a real breakthrough in the logistics of stock trading was actually achieved. The advent of the computer allowed traders to access data on a level never before seen or thought possible. With an initial investment of $30 million from Merrill Lynch, Bloomberg designed and built the first computer system to use real-time market data to quote stock prices and relay information.
By the late 1990s, the SEC ruled in favor of creating electronic stock exchanges. This laid the groundwork for a new type of trading: high-frequency trading or HFT. In just a couple of years, nearly 10% of all trades were done using HFT with a clearing time of just a few seconds. HFT is actually a thousand times faster than traditional human-to-human stock trading.
Understanding the World of High-Frequency Trading
High-frequency trading is an automated trading platform that executes buy and sell orders based on an algorithmic computer program. It’s a type of trading strategy implemented by large financial firms, such as hedge funds and investment banks, that allows them to trade millions of shares every day in transactions that often last less than a second.
Complex algorithms designed to analyze multiple financial markets and spot trends are the driving force behind HFT. These systems find arbitrage opportunities, pricing inefficiencies, and emerging trends using mathematical formulas that predict market movements and automatically execute trades. They move in and out of positions at an incredibly fast rate and almost never hold any position overnight, making these types of trading firms very liquid.
HFT strategies are purely algorithmic models that attempt to take advantage of mathematical opportunities and should not be confused with other investment strategies that utilize fundamental analysis and long-term growth planning. The method is risky because it deals with orders of magnitude higher than traditional investment models and therefore is not suitable for individual investors.
Many critics claim that HFT is an unfair practice that hurts smaller firms and individual investors because larger firms are able to take advantage of situations to which others do not have access. Proponents, however, point out that HFT increases liquidity in the financial markets and can lower bid-ask spreads for all investors.
High-Frequency Trading Since 2000
The advent of HFT at the turn of the millennium saw trades taking just a couple of seconds to clear and encompassing around 10% of all trade executions. Within just five years, HFT made up 35% of all stock transactions. From 2005 to 2009, high-frequency trading volume increased by 164%.
HFT was responsible for more than half of all trade executions by 2010. In May of that year, computer-based trading sold off more than $4.1 billion in equity holdings, triggering a flash crash in which the Dow plunged nearly 1,000 points in a single day. The initial sell-off triggered a wave of other sell-offs based on the designed algorithms, causing the extreme drop in values. While stocks quickly recovered, the SEC and CFTC conducted a joint investigation into the causes and became fully aware of the dangers associated with computer-driven trading platforms.
Trading times reached nanosecond speed in 2011 when firms developed microchips capable of processing trades at never-before-seen speeds. By 2012, nearly 70% of trades were accomplished using HFT. The same period brought a wave of HFT investments, including a transatlantic cable laid for the sole purpose of shaving milliseconds off of trading time and social media-based trading platforms that execute trades based on trending topics.
As social media proliferated throughout the financial industry, a false tweet in 2013 triggered a brief panic sell-off, wiping 143 points off the Dow in a matter of minutes. The sheer speed and volume of HFT was once again demonstrated when the Fed announced its plan to taper quantitative easing—over $600 million were traded in milliseconds before the news hit the mainstream media.
What the Future Holds for HFT
HFT has been the subject of ongoing regulatory discussions. Italy was among the first to implement an HFT trading fee to discourage certain types of high-speed investment activity. Regulators globally have been discussing new ways to manage HFT trading, and additional rules have been implemented to curb dangerous trading activity that poses systemic risks.
Despite regulatory scrutiny, the HFT industry continues to evolve. Since the flash crash in 2010, HFT platforms have been revamped to better assess risks and include circuit breakers. Stock analysis has increasingly given way to a more mathematical and technological approach whereby a single company’s balance sheet and earnings become secondary to algorithms designed to spot trading trends and pricing inefficiencies.
The Bottom Line
The real question moving forward is whether traditional investment models can still be used alongside HFT. If HFT prevents long-term investment planning, then it could pose challenges to the broader financial system. So far though, aside from momentary lapses in technology, HFT hasn’t fundamentally disrupted long-term investment strategies and has arguably helped introduce additional liquidity to the marketplace.
Frequently Asked Questions
Can individual investors use high-frequency trading?
No, not in any practical sense. HFT requires massive infrastructure investments—specialized hardware, co-located servers at exchange data centers, proprietary algorithms, and direct market access. The costs run into millions of dollars, and the margins per trade are fractions of a penny, requiring enormous volume to be profitable. Individual investors are better served by traditional investing approaches.
Does HFT make the market more or less fair?
This remains hotly debated. Critics argue HFT firms have unfair speed advantages and can front-run orders. Supporters counter that HFT has dramatically reduced bid-ask spreads (lowering trading costs for everyone) and increased liquidity. The reality is nuanced—HFT has brought both benefits and new risks to market structure.
What caused the 2010 Flash Crash?
The May 6, 2010 flash crash was triggered by a large sell order in E-mini S&P 500 futures contracts, which was executed via an algorithm that didn’t account for market impact. As prices dropped, HFT firms withdrew liquidity, and other algorithms accelerated selling, creating a cascading effect. Markets recovered within minutes, but the event led to new regulations including circuit breakers that halt trading during extreme moves.