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high-frequency trading (HFT)

Contributor(s): Ivy Wigmore

High-frequency trading (HFT) is the use of sophisticated algorithms and high-end hardware optimally located to gain an advantage in stock market trading. 

Here's how high-frequency trading works: The stock market sells high-frequency traders the right to place their hardware in close proximity to stock market systems. Software on the HF trader's system receives an alert about an order submitted by another trader, submits an order and purchases those stocks before first trader's transaction goes through. The HF trader's stock purchase marginally drives up the stock's price. 

The trader who submitted the original order consequently has to pay that higher price for the stocks, which benefits the HF trader. It all happens very, very quickly: The HF trader's transactions might complete in milliseconds, in contrast to a second or two for the original trader's transactions. 

On a per-trade basis, the practice is not lucrative; however, traders who use the system can make a great deal of money because of the large volumes of trades made over a period of time. According to financial journalist Michael Lewis, in aggregate, high-frequency trading firms generate profits of tens of billions of dollars annually. Lewis, a former trader and the author of The Big Short and Moneyball, also wrote a book about high-frequency trading called Flash Boys: A Wall Street Revolt. 

High-frequency trading is, at best, an example of gaming the system and, at worst, an illegal loophole created and perpetuated by those who profit from it. According to some analysts, the practice is simply an automated version of  insider trading

Charlie Rose interviews Michael Lewis on 60 Minutes:

This was last updated in May 2014

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