Trading in Microseconds

High-frequency trading is a hot topic in the financial world — the subject of ongoing federal and state investigations, new regulations by the European Union, and a recently released popular book, Flash Boys, that has further stimulated media and public interest.

As an investor, you may have questions about this cutting-edge, computerized trading strategy — which typically accounts for more than half of trading activity on U.S. exchanges — and how it might affect your own investments.1 It might be helpful to begin by considering some key aspects of the modern stock market.

Wall Street in New Jersey

The traditional stock exchange was a trading floor where human traders shouted buy and sell orders, as exemplified by the New York Stock Exchange (NYSE) on Wall Street. Today’s automated trading typically occurs on high-speed computer servers located in New Jersey.2

Although most U.S. stocks are listed on the NYSE or the NASDAQ, there are 16 SEC-registered exchanges where securities are traded, dozens of private exchanges (also referred to as “dark pools”), and hundreds of broker-dealers that can execute trades internally.3 A given trade, especially a large transaction, may involve multiple exchanges.

In this electronic world, there are tiny differences in the speed at which a trade is executed on one exchange versus another; they depend not only on computer speed but also on the Internet connection between the trader’s computer and the exchange. These differences are measured in milliseconds and microseconds: one-thousandth of a second and one-millionth of a second, respectively. A blink of the human eye takes about 350 milliseconds or 350,000 microseconds. The fastest high-frequency trading (HFT) firms can execute a trade in less than 10 microseconds — if the exchange can keep up.4

Built for Speed

Using sophisticated algorithms and ultra-fast computer connections (often co-located with exchanges for a fee), high-frequency traders probe market activity and profit from small price differences among securities on multiple exchanges. HFT firms may utilize several strategies.

Arbitrage — Identifying and acting on small inconsistencies in the price of a security or related assets on multiple exchanges.

Front running — Noticing that an investor is trying to place an order and buying it before the deal can be processed in order to sell it to the investor at a slightly higher price.

Market anticipation/ignition — Initiating and canceling a large number of orders in order to gauge or stimulate market movement.

Market making — Profiting from bid/offer spreads and rebates that exchanges offer to large-scale traders to provide liquidity; i.e., to help ensure that a buyer is available for a seller, and vice versa.

The amount that an HFT firm earns in any transaction may be a fraction of a cent per share, but by trading millions of shares the profits add up. Moreover, the liquidity provided comes at little risk, as shares may be held for less than a second. Some HFT firms end the trading day “flat” without holding any shares.5

Regulatory Scrutiny

High-frequency trading drew wide attention after the May 6, 2010, “flash crash” — when the Dow dropped 600 points in about five minutes, only to quickly recover — caused in part by the sudden disappearance of HFT firms from the market.6

Although high-frequency trading is not illegal, certain practices are being investigated by the SEC, the U.S. Commodity Futures Trading Commission, the FBI, and the New York Attorney General’s office.7–8

In January 2014, the European Union introduced rules requiring HFT firms to have circuit breakers to stop the trading process if price volatility becomes too high and requiring that algorithms be tested under regulatory supervision.9 Among controls being considered in the United States are a transaction tax and a minimum trading time.10

HFT and the Average Investor

Proponents of high-frequency trading claim that it has helped reduce spreads and other transaction costs for the average investor. Though it’s true that costs have fallen due to a variety of factors related to competition and technology, detractors believe that HFT firms have an unfair advantage and may artificially increase short-term prices.11

For individual investors, the role of HFT in the market is probably not cause for concern, and it should not prevent you from carrying out an appropriate long-term investment strategy. In fact, by adopting a long-term strategy, you are more likely to benefit from potential market growth and less likely to be affected by the microsecond movements created by high-frequency trading.

All investments are subject to market fluctuation, risk, and loss of principal. Investments, when sold, may be worth more or less than their original cost.

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JON TEN HAAGEN, CFP, RPC
Your Investment Portfolio Repairman
Founder and CEO
Ten Haagen Financial Group
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1, 3, 5) U.S. Securities and Exchange Commission, 2014
2) The Star-Ledger, July 14, 2013
4, 6) Bloomberg Businessweek, October 16, 2012; June 6, 2013
7) The Wall Street Journal, April 1, 2014
8, 11) Bloomberg.com, April 7, 2014; March 31, 2014
9) CNBC, January 15, 2014
10) The Financial Review, May 2014

The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2014 Emerald Connect, LLC