High-frequency trading (HFT) is trading by computers that place and cancel orders thousands of times a second, with the firm's own money, to earn tiny differences in price. HFT firms are also called proprietary trading firms, because they trade the firm's own money, not clients' money. The most common kind of HFT is market making.
A market maker always offers both to buy and to sell the same share or contract. The price at which it offers to buy is called the bid. The price at which it offers to sell is called the ask. The ask is slightly higher than the bid. The small gap between them is called the spread, and this gap is how the market maker earns.
Say a market maker offers to buy a share at ₹250.00 and to sell it at ₹250.05, for 1,000 shares on each side. An investor who wants to sell sells 1,000 shares to the market maker at ₹250.00. A moment later, another investor buys 1,000 shares from it at ₹250.05. The market maker has earned ₹0.05 × 1,000 = ₹50, before charges. It repeats this millions of times a day, across thousands of shares and contracts. Its risk is that the price moves before it can sell what it has bought.
Speed decides who wins. Every change in price on the exchange's data feed starts a new calculation of the firm's prices. The firms place their servers inside the exchange's data centre, close to the matching engine. This is called co-location. Their programs are written in fast languages such as C++. Some firms even put the trading logic on special chips. A reaction is measured in microseconds, millionths of a second. At the end of the day, all their trades go to clearing and settlement like everyone else's.
Supporters say that market makers make trading cheaper for everyone, because there is always someone on the other side and the spread stays narrow. Critics say that the speed advantage is unfair to slower investors.
India matters a great deal to these firms. India's exchanges now trade more equity options contracts than any other market in the world, and individuals make up more than a third of the trading in index options. Global market makers have come to trade in India for this reason. SEBI has tightened the rules on individual options trading, and these firms are the most affected by where those rules end up.
HFT is different from a hedge fund, which invests clients' money and usually holds positions for days or months. It is also different from execution algorithms, which carry out a client's large order.