What you need to know about high-frequency trading

High-frequency trading (HFT) is a stock, bond, or other security algorithmic trading model that uses very fast (the fastest) technology to trade in and out of investments. So fast that an HFT model can go in and out of the same security in less than a second. So fast that some HFT firms actually have fiber optic cable connected directly to various market exchanges! I don’t think TDS or Charter offers that yet.

Did I lose my readers already? What’s the point?

Well, with the right tools and technology (primarily super-fast-thinking computers and super-fast cable connections), HFT firms can squeeze out a fraction of a cent, or a penny here or there, on every trade before the average Web-connected investor could. Some accounts suggest that HFT makes up 50% to 70% of U.S. stock market volume.

Who cares about a penny?

You should, because that penny adds up to millions in profits to HFT firms, and it’s gained at the expense of the average investor and even more sophisticated money managers. I’m all for profit making, but not when the playing field isn’t level.

For example, HFT firms can do the following things that we simply can’t:

1. Trade faster than anyone when information is released.
2. Trade ahead of when index funds rebalance. Index fund rebalancing causes very short-term movements in the stocks coming in and out of the index. HFT firms can get ahead of those trades.
3. Capture trades actually made by other investors who are not dialed into fast connections and fast computers. HFT firms can jump in front of a trade, buy the security, and then sell it right back to you, marking it up, because they can see the trade coming and get in and out first before you even know what happened. 

And those are just a few of the advantages. There are many more strategies beyond my comprehension. And yet this concept is not new. It’s been around since at least the beginning of the century (21^st, not 20^th), but its use has grown exponentially in the past 10 years. I’ve been gathering research on this for some time now and have grown frustrated with the following:

1. I don’t know what I don’t know. In other words, as much as I’ve tried to understand all of this stuff, it’s intense and complex, and my tiny brain is tapped out. A lack of transparency will do that.
2. Ordinary investors are even more clueless about this (most don’t even know HFT exists!) and are therefore at a competitive disadvantage if they’re trading against or into an HFT firm’s trade. Unfortunately, they wouldn’t really know this because it hasn’t gotten the coverage it deserves in the mainstream media (until now!).
3. This lack of transparency and the ability of some firms to get special access concerns and upsets me. 

This awareness is additional fuel for the “don’t try to time the stock market” mantra I often regurgitate. I’ve always said this, but add in HFT, and the idea that an investor (or an average or sophisticated money manager for that matter) has any sense of short-term value and can then exploit that awareness is naïve in my opinion. HFT can get there first.

(Continued)

Fortunately, and finally, we have someone in the “mainstream” (there have been many wonderful writers discussing this outside of the mainstream for years) who’s doing a good job of exposing how HFT can affect the average investor and, more importantly, the mainstream media are finally listening. That means the average investor should also start listening.

Michael Lewis, author of some of the better behind-the-scenes books on the investment industry, has just released his newest book, Flash Boys. Lewis has the cachet to make a dent in the world’s understanding of issues like this, even though other books, such as Dark Pools by Scott Patterson or The Problem of HFT by Haim Bodek, are also good reads and have been ahead of this discussion for a couple of years now.

In the meantime, you should watch this recent 60 Minutes interview with Michael Lewis. It’s fascinating to say the least.

Watching this should justifiably tick you off, but we need to begin somewhere, and the sooner the average investor is armed with this knowledge, the sooner the playing field can be leveled again.

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

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