High frequency trading has been in the news over the past couple of years. It has been maligned as market manipulating and blamed for crashes. It accounts for 70% of equity trades in the US. There was a recent interview with Arzhang Kamarei, Partner at Tradeworx, published at allaboutalpha.com. Tradeworx is a quantitative investment management firm that uses high frequency trading to run equity market neutral hedge funds.
Most high frequency trading firms are market makers and provide liquidity for securities. They make money by "rebate capture" and on the bid-ask spread while acting as a principal. The rebate is offered by the exchanges $0.0025 per trade. There is a distinct advantage in being faster and having your trade orders in the exchange before others. When your trade is in the front, there is a better chance of having it executed at the bid price.
These firms like markets that allow them to end the day with no net exposure, have trading venues with low latency, have securities with lot sizes small enough for risk control and where automated market making have an advantage. They like volatile markets because there is high trade volume. The more trades - the more money they make.
High frequency traders have to watch their inventory. They need to diversify across securities and keep their net balances low - same as with portfolio managers.
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