by Alexander Green, Chief Investment Strategist, The Oxford Club
Monday, October 22, 2012: Issue #1887
I occasionally hear from readers who say they are fleeing stocks because they fear a market crash due to the prevalence of high-frequency trading.
This is almost certainly a mistake. Here’s why…
High-frequency traders rapidly buy and sell large amounts of securities with statistics and algorithms that drive electronic-trading strategies. Using high-speed data systems, linkages with underground networks, and locations strategically positioned close to the servers of electronic exchanges, they compete to buy and sell in increasingly smaller fractions of a second.
Their influence is substantial. High-frequency traders now make up approximately half the daily volume on U.S. stock exchanges.
Critics claim that these traders are high-tech pirates who destabilize the markets and cost most market participants money. Not so.
High-frequency traders spot and capitalize on very small discrepancies in bid/ask spreads among various exchanges. In the process – as both Berkshire Chairman Warren Buffett and Vanguard Founder John Bogle have pointed out – they tighten those spreads and increase market liquidity. These are both good things for ordinary investors.
Trust me, high-frequency traders aren’t doing anything the average trader or investor is doing anyway.
They are essentially vacuuming up nickels and dimes. Daniel Weaver, Professor of Finance and Associate Director for Whitcomb Center for Research in Financial Services, points out that the average high-frequency trader’s profit is 10 cents on every 100 shares traded. My guess is that’s not your investment objective.
How about the complaint that high-frequency traders make stock prices more volatile?
Again, this simply isn’t true. Investigators have already concluded that the flash crash of May 6, 2010 and other recent market hiccups were caused not by high-frequency trading but by erroneous orders and other technological glitches. In fact, as high-frequency trading has increased, market volatility has actually declined. The Dow’s 1,100-point advance over the last four months, for instance, has been remarkable only for its smoothness.
I’m not saying a stock market crash isn’t possible. It certainly is and every investor should plan for this contingency. However, the SEC has installed circuit breakers that will halt market-wide trading if the Dow suddenly drops 10%, 20% or 30%.
This is designed to give traders and investors an opportunity to stop and re-check their sanity if a panic were to ensue for whatever reason. In truth, however, if high-frequency trading were responsible for a sharp break in the market, you should rub your hands together and click your heels.
After all, only a tiny fraction of any company’s shares change hands on any given day. Yet these transactions determine the buy and sell price for the entire firm. If a company’s share price were to suddenly nosedive without any change in its fundamentals or business outlook that would represent an unequivocal buying opportunity.
To illustrate the point, imagine that every piece of real estate carried real-time bids and offers during market hours each day. If you saw a piece of land, a home or an office building suddenly selling for half what it was the day before, what would you do? Panic and sell your own home? Sit on your hands and do nothing?
I’d like to think that if you had any money or any sense, you’d step up and take advantage of the mispricing. In other words, you’d buy.
Stocks are no different. A high-frequency-induced trading crash, though unlikely, might provide you with the buying opportunity of a lifetime.
As every seasoned investor knows, price is what you pay. But value is what you get.