High Frequency Trading (HFT) - Why It’s Just “Random Noise”

“Pay no attention to that man behind the curtain,” the Wizard of Oz

What is HFT?

Much has been written about High Frequency Trading (HFT) since Michael Lewis’s 60 minutes appearance and his new book Flash Boys has created a major buzz within the industry.

HFT- the rapid fire, electronic execution of extremely large buy and sell orders at various stock exchanges, has been blamed for the sudden “flash crash” of 2010, and now the claims of a “rigged” stock market. Lewis is a great writer, and his description of a million dollar hand of Liars Poker played on the bond trading Desk of Solomon brothers in the 80’s, was clearly a career-changing event.

But the question remains - are true retail investors like you and I getting the shaft on HFT?

How Does HFT Work?

Although the claims of the market being “rigged” have elements of truth, it doesn’t affect true investors that much. The obvious defense of this type of trading: increased overall market liquidity, and the theory it creates more competitive market pricing for all.

If you buy this argument or not, you should recognize investing is not a daily or even weekly event. The theoretical increased cost of say 2cts when purchasing 250 shares, raises the cost of your investment by $5.00. Clearly not great, but if you are reallyinvesting in a business, spending thousands of dollars, and $5.00 is your make or break point, stop now and step away from the phone, you should just not be buying. The only way this type of cost increase really matters, is if you are a day trader, a gambler, or purchasing a 100,000 shares.

Ok, some facts: a $300 mm fiber optic line was built privately and run as directly as possible from Chicago to the stock exchange computer servers in New Jersey. The New York Stock Exchange is no longer a busy open outcry market, with traders battling crowds at their respective posts. Once a place where many Monmouth and Ocean County residents worked, including some who made the actual markets in America’s greatest companies, but alas it is no longer. Now it’s more of a theatrical zone than anything else. A place where TV cameras crews roam and actual traders a dying breed.

This new fiber optic “Pipeline” became the quickest route to execute a stock order and certain traders paid millions to gain access to this private electronic superhighway. The exchanges themselves actually sold high speed connections to the traders willing to pay extra. Soon complex computer driven algorithms were designed to send a series of orders along with rapid-fire cancellations to test market depth and balance.

Often these traders quickly reversed course after discovering large institutional orders. Once these orders were discovered, and seriously not your 250 share order, these “algo traders” won the electronic footrace between a NJ consolidation midpoint and the actual exchange server somewhere else in NJ. This “strategy” effectively allowed bigger and faster (hence high frequency) traders to “front run” any potential large orders by taking a position ahead of them.

OK, not so retail friendly, we admit, but similar types of situations have unfortunately long been a part of the stock market. Back when actual humans made a market in a stock 1/8th of a point wide (12.5 cts) smaller orders often didn’t get the best execution. Ultimately, under competitive pressures, the New York Stock Exchange narrowed the difference between its buying and selling price to just pennies, and that’s when the business model of a typical floor trader collapsed, soon after the machines took over.

What HFT Means to You

Now, let me explain what this all means to you.

Chasing higher returns, i.e. trying to save pennies, is the bane of the average investors existence (but not you of course, you’re above average!), mutual fund holders often do worse than their actual fund’s average return.

Why?  Because they get out too early or buy into a fund too late. In short chasing 'hot" trends and trying to time the market. A five year study by Morningstar, reported in the Wall Street Journal, showed investor performance trailed their actual funds average by 1.17 %, compound that difference over a period of 20 years and you really miss a lot of upside. 

It’s also worth remembering, according to S & P Capital, of all bear markets since 1945, those down between 20-40%, the average time to recovery is just 14 months. The lesson here, work with an advisor, establish an appropriate and comfortable “risk” position and don’t try to time the markets - that’s just gambling, ultimately a loser’s game, not investing.

Next blog: What actually is Asset Allocation? Hint: think diversity.