News stories about High Frequency Trading (HFT) have exploded since the discovery that some HFT traders are using technology to unfairly profit, leaving some investors wondering if the whole stock market is completely rigged against them. In fact, HFT can both help and hurt investors.
To understand the impact of HFT, it’s helpful to understand trading dynamics. When I started investing, stock trades were executed largely via “floor trading” - a group of traders standing in a circular pit on the floor of a stock exchange, shouting red-faced, hand-signaling prices and order sizes, and writing down completed orders on slips of paper - a manually intensive process prone to error. Today, nearly all trades are completed electronically via computer systems, eliminating floor traders and the inherent limitation of human capabilities. This improves “market efficiency” - filling orders quickly and at fair prices – which benefits all investors.
What is High Frequency Trading?
Using computerized algorithms and high-speed networks, HFT firms respond quickly to a stock’s momentum to buy and sell at a profit. HFT firms trade thousands of orders every day (which actually improves market efficiency). Speed equals profits for HFT firms.
But in 2013, it was discovered that a few HFT firms profited unfairly from their speed advantage. When their computers saw a large buy order heading toward a stock exchange it immediately sent the same buy order over its super-fast network to beat the original one - and then waited for the first order to come in and sell the shares at a higher price. It’s like being able to see a line of cars speeding toward a pot of gold and then jumping in your NASCAR to beat them to it. It’s this skimming of profits that’s irking investors.
How does High Frequency Trading Affect Me?
Though the prices paid might only be a few pennies higher per share, it’s estimated that skimming brought millions of dollars in profit for these firms. Charles Schwab, founder and chairman of the brokerage firm that bears his name, recently said in a statement that “High-frequency traders are gaming the system.” However, Vanguard Group, the world’s largest mutual fund company, in 2010 said “We believe that a vast majority of ‘high-frequency trading’ is legitimate and adds value to the marketplace.”
For the few bad apples who are skimming profits ahead of everyone else, the markets are already evolving to eliminate their unfair profiting. With the recent subpoena of a few HFT firms by the New York Attorney General’s office, we may see legal repercussions. Between the market changes and fears of dealing with the NY AG, I expect this form of skimming will soon become obsolete.
Gary is an Accredited Investment Fiduciary and CERTIFIED FINANCIAL PLANNER practitioner in Pleasanton, CA. As fee-only investment advisors, we serve the communities of Pleasanton, Dublin, Blackhawk, Danville, San Ramon, Livermore and the greater San Francisco Bay Area.