Investment U Explains: High-Frequency Trading

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club

Editor's Note: There's no doubt that high-frequency trading is a hot topic amongst investors. That's why we decided to cover it in this installment of Investment U Explains. And, in case you missed it, Chief Investment Strategist Alex Green had a lot to say about high-frequency trading in a recent article. You can read his article below.


Are You Getting Robbed by High-Frequency Thieves?

Americans today are increasingly obsessed with the issue of "fairness."

This obsession is now spilling over to the stock market, where certain folks - including Michael Lewis, the best-selling author of Flash Boys - claim that high-frequency traders are using a technology advantage to cheat ordinary investors.

The technology advantage is real. The harm done is more imaginary. 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 Berkshire Chairman Warren Buffett, Vanguard founder John Bogle, former SEC Chairman Arthur Levitt, and Burton Malkiel, father of efficient market theory, have all pointed out - they tighten those spreads and increase market liquidity. These are both good things for ordinary investors.

When I started out as a stockbroker 30 years ago, spreads were generally an eighth of a point on a large stock and a quarter or more on a small one. But increasing volume and technology have brought this down to a penny or two for most stocks. This is a huge advantage for short-term traders, perhaps even bigger than the enormous drop in commissions that has taken place over the same period.

Not Your Game

High-frequency traders don't do anything the average trader or investor could do, anyway. They are essentially vacuuming up pennies and nickels. Daniel Weaver, professor of finance and associate director for the Whitcomb Center for Research in Financial Services, points out that the average high-frequency trader's profit is $0.10 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. Ask anyone who trades the VIX and they will tell you volatility is down over the past few years, not up. And investigators concluded that the "flash crash" of May 6, 2010, was caused by a single large sell order on E-Mini futures contracts, a security that mimics trading in the S&P 500 index. High-frequency traders reduce distortions. They don't increase them.

However, one practice should be outlawed. Optimally positioned traders can see trade orders from other investors before they are executed. This gives them an opportunity to act first, driving the price up a few cents and pocketing the difference. This is actually "front-running," a form of insider trading. It's illegal when done by a human being. It should be when done by an automated computer as well.

Protect Yourself

But while you're waiting for someone to address this regulatory issue, there's a simple way to prevent anyone (or any machine) from profiteering off your trades. Use a limit order.

If a stock is offered at $12.25, for instance, put a limit order in at $12.25 - or slightly lower. If it isn't filled instantaneously, it usually will be within a few minutes.

This is greatly preferable to asking the government to prevent or punish high-frequency trading. In Europe, when trading taxes were implemented, trading volume dropped and so did liquidity. Bid-ask spreads increased. The same thing happened in Canada when new trading fees were introduced.

Those clamoring for a new tax on financial transactions to curb high-frequency trading should be careful what they wish for.

Likewise, you probably have more important things to worry about than whether someone is skimming a penny off your market orders.

Then again, it could just be the new modern disease. It's called a fairness fetish.

Good investing,

Alex

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