High Frequency Trading: You might not have heard of it now, but get ready, because it's going to be
everywhere in the next few weeks. After the New York Times' exposed how advanced Wall Street computers can execute impossibly complicated, and possibly unfair, stock trades, Sen. Chuck Schumer
(D-NY) asked the SEC to ban certain types of high frequency trading, or HFT. But what is HFT exactly, how does it work?
There is still a lot of uncertainty about how exactly these trades are executed. As the Times reported in a very clear graphic, computers can "peek" at trade orders 0.3 seconds before they are executed, and actually buy the stock milliseconds before it goes up in value. During this process they "ping" (or listen to) the prices, learning how much people are willing to pay by making a flash bid -- a bid to see the maximum price other buyers are willing to pay.
How does that work? Here's a down-and-dirty analogy in which I'll play the role of the flash trader. Imagine if eBay had a rule where you could cancel your bid within 1 second. I put up some stuff on ebay, and you place a bid for it. Then I place a bid that is higher than the current bid to see if that becomes the new highest bid. If it is, I cancel it within milliseconds. Remember, I don't want to buy the product -- I just want to drive the price higher! This is similar to what critics of HFT think is going on; HFT is able to ping prices with bids that exist for only milliseconds to see how much other buyers are willing to pay to squeeze out the maximum profit.