High Frequency Trading

High-Frequency Trading: What is it and how are retail investors impacted?

by

In the last week, Michael Lewis’ comments in a 60 Minutes interview kicked off a media frenzy about high frequency trading (HFT). Introducing his new book, “Flash Boys,” the business writer now famously said to Steve Kroft, “The United States stock market, the most iconic market in global capitalism, is rigged. It’s crazy that it’s legal for some people to get advance news on prices and what investors are doing.”

Rigged, the word everyone has focused on.

And as the week progressed, the HFT conversation snowballed as the FBI announced it was seeking HFT whistleblowers; the Justice Department’s Attorney General Eric Holder said an investigation would be launched and the two regulatory agencies, the Commodities Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC), confirmed they already have open HFT investigations.

Also during this time, everyone again started asking, what’s a retail investor to do with HFT? How is he affected by this type of trading?

We’re here to give you a little primer on HFT and hopefully answer some of your questions.

 

What is High Frequency Trading?

According to Investopedia, HFT can be defined as “a program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”

How do these HFT traders receive top prices? They do so by stepping ahead of others as their trades are executed first while others investors’ transactions come in with lower profits, reported The New York Times.

Therein lays the challenges but by doing a large number of trades daily, these HF traders are making money by a speed and data advantage.

 

How prevalent is High Frequency Trading?

In October, HFT represented a 35 percent-plus percent for spot currency trading, up from October 2008’s 9 percent figure, according to the research firm Aite Group. Meanwhile, for equities, there’s been an opposite trend as high-frequency activity represented 50 percent of 2012’s stock trading, off from 2008’s 66 percent number, reported Rosenblatt Securities.

However, high-frequency traders also represent about half of the U.S. share volume.

So it’s definitely out there in the marketplace.

 

Are there some positives to High Frequency Trading?

Sure, there are some HFT advocates who will say it creates more liquidity for the marketplace and provides price cuts for investors.

One reporter, Bloomberg’s Matt Levine, wrote that HFT diminishes the human factor as large, savvy firms have advantages over small investors through greater information. This benefit allows more opportunity to respond faster to changing market conditions.

Yes, there’s the speed advantage but some will also say that HF traders receive a benefit as their computer servers are “next to” these big exchanges, decreasing the time an order will go from the computer to exchanges’ electronic matching engines.

Faster paths such as microwave towers and fiber-optic cables are also part of the equation as they create quicker trades between markets across the country (what, a trade to be executed from Chicago to New York? No speed problem here).

Other proponents will say with its increased liquidity, High Frequency Trading tightens market spreads.

A.K.A. the price difference between buying and selling a stock)

Making trades for the average stock investor less expensive.

It’s hard to argue that’s not a good thing.

As an individual investor, should I be concerned about High-Frequency Trading?

Yes, it’s understandable that you are concerned; however, some pundits have come out and said to relax–with one saying stay away.

CNBC’s outspoken Jim Cramer recently said, “High-speed trading is “unfair” to day traders, but as a “normal individual investor” you should already not be participating in day trading.

He added, “If you’re playing this game at home and you’re trying to beat these guys, forget it. That’s not the right game.”

Rather, he is a proponent of an investor putting $10,000 into the Standard & Poor’s 500 and then having around 25 percent of individual stocks in a portfolio. Why do this? Cramer explained, “The market for the last five years proves that if you buy high-quality companies and hold onto them, you can make a great deal of money.”

Others have said retail investors aren’t competing against HF traders but instead these speedy traders are going up against one another to fill your order–which could result in you getting better fills from your broker.

We can’t tell you to not worry. It’s likely to remain in the news for a while. It’s understandable to be concerned but don’t let it stop you from keeping your eye on the investment prizes: saving, investing and making good financial decisions.

 

Sign Up Today for Instant Access

To Our Financial Planning Newsletter

  • News, Updates & Alerts
  • Fresh Ideas & Perspectives
  • Written in Plain English

BONUS


Key Investment Strategies Hidden in Plain Sight

3

Send this to a friend