How Does High-Frequency Trading Work?

High-frequency trading -- sometimes also called "algorithmic trading," "algo trading" and "black box trading" -- refers to an extremely active trading strategy in which investors buy and sell stocks, commodities, currencies, options or other securities very frequently. The goal is to take advantage of very short-term fluctuations in asset prices -- sometimes lasting for just minutes or seconds -- before trading out of them.

Algorithmic traders program computers to buy and sell securities automatically when certain market conditions are met. The computer then executes the trade progammed -- buying and selling at the appropriate points -- with little or no prompting or interaction with the investor. The theoretical advantage to algorithmic trading is that it takes the emotions out of the investing process. Further, once the programming is done, the investor does not need to continue to micromanage his portfolio. The computer, in theory, does that for him.

Whether the investor uses an algorithmic approach to trading or makes frequent trades manually, he typically uses specialized day-trading software that helps track the performance, pricing and volume data on his selected securities and indexes. The software connects him automatically with one or more broker/dealers, or stock brokerages, that handle the buying, selling and record-keeping on the investor's behalf.

The high-frequency trader must concern himself with several costs, in order to function and survive as a trader. The first is the costs of the technology, meaning the software and computer equipment needed. The second is transaction costs -- principally the commissions charged by the brokerage company. There is another cost -- called the bid/ask spread -- that is hidden from the investor. This is the difference between the price a brokerage obtains a security for and the price it charges the buyer. With small or illiquid stocks, this bid/ask spread can be significant. Lastly is taxation. In the U.S., the investor must pay a capital gains tax on all profitable trades, unless the trade is canceled out by an unprofitable one. Short-term gains are taxed at a higher rate than long-term gains. If the investor is conducting his investing as a business, then he is subject to income tax, rather than capital gains tax, on profits.

The Securities Exchange Commission subjects those making a living as high-frequency traders, or day traders, to certain special regulations. For example, day traders must keep a minimum of $25,000 in their trading accounts at all times. Day traders must also comply with strict margin rules on accounts in which they plan to trade with money borrowed from their broker. Further, if the IRS deems that the trader is doing short-term trading as a business, then any profits will generally be treated as ordinary income, rather than capital gains, for tax purposes.