Secrecy, Strategy and Speed are the terms that best define high frequency trading (HFT) firms and indeed, the financial industry at large as it exists today.

HFT firms are secretive about their ways of operating and keys to success. The important people associated with HFT have shunned limelight and preferred to be lesser known, though that's changing now.

The firms in the HFT business operate through multiple strategies to trade and make money. The strategies include different forms of arbitrage – index arbitrage, volatility arbitrage, statistical arbitrage and merger arbitrage along with global macro, long/short equity, passive market making, and so on.

HFT rely on the ultra fast speed of computer software, data access (NASDAQ TotalView-ITCH, NYSE OpenBook, etc) to important resources and connectivity with minimal latency (delay).

Let’s explore some more about the types of HFT firms, their strategies to make money, major players and more.

HFT firms generally use private money, private technology and a number of private strategies to generate profits. The high frequency trading firms can be divided broadly into three types.

The most common and biggest form of HFT firm is the independent proprietary firm. Proprietary trading (or "prop trading") is executed with the firm’s own money and not that of clients. LIkewise, the profits are for the firm and not for external clients.

Some HTF firms are a subsidiary part of a broker-dealer firm. Many of the regular broker-dealer firms have a sub section known as proprietary trading desks, where HFT is done. This section is separated from the business the firm does for its regular, external customers.

Lastly, the HFT firms also operate as hedge funds. Their main focus is to profit from the inefficiencies in pricing across securities and other asset categories using arbitrage.

Prior to the Volcker Rule, many investment banks had segments dedicated to HFT. Post-Volcker, no commercial banks can have proprietary trading desks or any such hedge fund investments. Though all major banks have shut down their HFT shops, a few of these banks are still facing allegations about possible HFT-related malfeasance conducted in the past.

How Do They Make Money?

There are many strategies employed by the propriety traders to make money for their firms; some are quite commonplace, some are more controversial.

The Players

The HFT world has players ranging from small firms to medium sized companies and big players. A few names from the industry (in no particular order) are Automated Trading Desk (ATD), Chopper Trading, DRW Holdings LLC, Tradebot Systems Inc., KCG Holdings Inc. (merger of GETCO and Knight Capital), Susquehanna International Group LLP (SIG), Virtu Financial, Allston Trading LLC, Geneva Trading, Hudson River Trading (HRT), Jump Trading, Five Rings Capital LLC, Jane Street, etc.

Risks

The firms engaged in HFT often face risks related to software anomaly, dynamic market conditions, as well as regulations and compliance. One of the glaring instances was a fiasco that took place on August 1, 2012 which brought Knight Capital Group close to bankruptcy--It lost $400 million in less than an hour after markets opened that day. The “trading glitch,” caused by an algorithm malfunction, led to erratic trade and bad orders across 150 different stocks. The company was eventually bailed out. These companies have to work on their risk management since they are expected to ensure a lot of regulatory compliance as well as tackle operational and technological challenges.

The Bottom Line

The firms operating in the HFT industry have earned a bad name for themselves because of their secretive ways of doing things. However, these firms are slowly shedding this image and coming out in the open. The high frequency trading has spread in all prominent markets and is a big part of it. According to sources, these firms make up just about 2% of the trading firms in the U.S. but account for around 70% of the trading volume. The HFT firms have many challenges ahead, as time and again their strategies have been questioned and there are many proposals which could impact their business going forward.