High frequency trading is trading that is carried out on a platform that allows for large numbers of trades at short time intervals. This is usually done by extremely sophisticated computers that are capable of analysing the markets and executing trades based upon prevailing market conditions. Usually, it is large investment banks or institutional investors that take advantage of high frequency trading. Although this type of trading is popular among some investors, there are real dangers and risks involved.
The reason why high frequency trading is popular is that these computers are able to pick up emerging market trends within a few seconds and are able to make trades quickly based upon those trends. By so doing, investors have somewhat of an advantage and are able to make substantial gains based on these trades. Even though the spreads on individual trades may be very small, when the huge numbers of trades are considered, the final result can be substantial profits.
One of the biggest dangers of high frequency trading is that it can increase the systematic risk within the financial markets. Since trading often occurs across several borders, market shocks have the potential to be transmitted very rapidly from one market to another. If the trades are large enough, this can have substantial consequences in the financial markets. There is also the possibility of spoofing which further distorts the financial markets by sending misleading signals that give the senders unfair advantages. Since financial markets are operated on the assumption of fair trading, anything that affects this fairness will negatively affect the markets. The Flash Crash of 2010 which was a result of spoofing, saw the markets plunging and then rebounding by 5 to 6 percent points within a few minutes.