Over the last eighteen months or so, the practice of high frequency trading (HFT) has been generating a lot of controversy in the equities markets. But what exactly is high frequency trading and why is it so controversial? And why are there so many misconceptions out there around these activities? This article will attempt to answer those questions.

First of all, a quick explanation. High frequency trading is where traders send multiple orders into the market electronically, to capitalise on opportunities arising from small differences in prices. Positions are generally only held for a few minutes at most, and high frequency traders always end the day flat.

This all sounds perfectly reasonable, so why is there so much controversy around the practice? For a start, the mechanics of high frequency trading is generally not understood by the investing public and where there is ignorance, there is fear. People think that if these computers are making money, it must be at their expense. Secondly, media coverage of high frequency trading is generally pretty negative, for a variety of reasons. And third, when events like the 6th May “flash crash” happen, they are attributed by various commentators to high frequency traders, regardless of the facts of what actually happened.

The misconceptions around high frequency are many and varied. For example, a common myth is that HFT causes market volatility. This is illogical when you think about it. Without market volatility there would be no high frequency trading, because there would be no price differences for the HFT strategis to take advantage of. HFT cannot both be the cause and effect of market volatility, they have to be one or the other. Otherwise they would have an infinite money-making paradox (a beneficial paradox but a paradox all the same).

Another myth is the amount of profits generated by high frequency traders. The typical profit for a single high frequency trade is less than 0.1 cent per share. Based on industry estimates of HFT volume (ten billion shares per day), that is a total of $2 billion per annum in profits, distributed across all the firms who are engaged in HFT. This is actually just a tiny fraction of the profits generated by the investment industry as a whole.

A third myth is that high frequency traders use technology to give themselves an unfair advantage over retail and institutional investors. This logic is flawed. The technology used by HFT firms is available to any and every market participant who is prepared to make the investment in that technology. In Formula One motor racing, do McLaren and Ferrari have an unfair advantage over smaller teams because they invest more in technology? No. They have an advantage but the advantage is not unfair because as the smaller teams invest more, their results improve.

Another misconception that is fairly common is that high frequency trading systems caused, or at least contributed to, the “flash crash” on May 6th. The reality is actually very different. If you look at the events of that day, once the market started collapsing, most HFT firms disabled their systems while they evaluated exactly what was happening and if there was some king of major news event of which they were unaware. Once it was clear that was not the case, they re-applied their systems and equilibrium was once again restored.

High frequency trading serves a useful purpose in that it provides liquidity in electronic markets by taking the opposing side of trades to institutional and retail investors who are buying or selling positions for the long term. In the same way as dealers and specialists used to make markets on the trading floors many years ago, high frequency traders serve a similar purpose now, they just do it faster and more efficiently.

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If you are keen to find out more about high frequency trading and high frequency trading misconceptions, a fantastic resource with articles, interviews and explanations can be found at the High Frequency Trading Review website