HFT (High Frequency Trading) Basics
The first quarter ended Monday with investors having seen little net benefit. While the Dow was fractionally lower for the period, the S&P500 and NASDAQ were each only fractionally higher. On Friday, right after the release of a pretty good non-farm payrolls employment report, the S&P and Dow each set new all-time highs. And then…the highly volatile, so-called momentum stocks got hit with a big wave of selling. Nonetheless, when we closed on Friday, stocks were generally higher, week over week, as the market’s internal rotation continues.
Earnings release season officially begins next week so those will likely be a focus of traders for the next few weeks.
“Flash Boys”
This is the title of a new book that a week ago, on a segment on “60 Minutes”, author Michael Lewis talked about. The segment caused a lot of commentary in the financial press about the main topic of his book…high-frequency trading or HFT. The author’s contention is that trading on Wall Street is “rigged” and that HFT is directly related to said rigging. I’ve had a quite high number of questions about these comments over the week so I thought that I’d share my thoughts to try to help you understand the concepts better.
Speed
I think the term, “high frequency” itself makes a lot of people uncomfortable. Speed can suggest reckless, maybe dangerous and therefore, somehow inappropriate activities.
From the time there have been markets, there’ve been traders trying to get an edge over their competitors.I’ll bet when, in the past, horses, carrier pigeons, the telegraph and mainframe computers were first used to speed information flow, those contemporaries were equally dazzled and/or concerned by the relative rapidity of the movement. Today, we’re talking about the speed of light through the use of fiber optic cables. This need for speed by the HFTs (high-frequency traders) isn’t to take advantage of individual investors; it’s to get or stay ahead of their competitors. So, speed itself is not a problem.
Rigged?
Here’s how I understand the concept of HFT.
Up until about 10 years ago, US stocks could only be traded in eighths of a dollar and, for the privilege of buying or selling fewer than 100 shares of anything, you were also charged an extra eighth. That was a license to print money for the folks on the floors of the exchanges. But, that wasn’t considered “rigging” – it was legal and how things were done.
The Securities and Exchange Commission then determined to promote more competition between exchanges, as well as to speed up the move to electronic trading, instead of going through the humans on the exchange floors. The result of all that was that we now have multiple exchanges and alternative trading systems with all these entities competing daily to attract order flows. The goal was to narrow the differences (spreads) between the buy and sell prices of shares from eighths down to decimals in order to provide the best possible prices to investors.
Another result has been a huge narrowing of the spreads, along with the commission costs to execute trades. This, in turn, has led to the HFT trading firms. These use high-speed computers and data analysis to discover price differences, as well as find indications that large orders are being executed. One way they do this is by subscribing to direct-access data feeds provided, for a fee, by the exchanges. Another is to place their servers as close to the exchange servers as possible – adding to the speed of light two way info flow. All these HFT systems are designed to be used by and for institutional investors – the really big money traders and investors – not us individual guys.
The effect on you
I heard one “expert” say that HFT was bad because those kinds of traders “insert themselves between trades.” Well, so too did the specialists on the exchange floors and the market-makers in the old OTC markets. And they did so with those effective guarantees of, at least, the eighth of a dollar minimum differences between prices. It’s from these and related groups that most of the carping has come from.
The HFTs make markets, buying and selling shares for a fraction of the bid and offer difference. They’ve gained favor simply because the computers are cheaper than the human traders and, due to the intense competition, they pass most of the savings back to investors. This, I believe, helps improve liquidity and gives us a better system overall than previously.
Small, as in not institutional investors, aren’t even considered by HFT traders. When you enter an online trade, buy or sell, when you push the button, your market order is instantaneously filled at the NBBO – National Best Bid/Offer. That’s the very best price in the market at the second you hit send. It’s done even before your browser has refreshed. And, it’s being done for a fee that’s a fraction of what it would have been even just 10 years ago. Matter of fact, Katie Henderson, a spokeswoman at Vanguard said, “The overall cost of investing in the equity market has actually come down significantly due to changes in regulations, technical enhancements and increased competition.”
Summary
All this talk of rigged markets has to be very confusing for most investors today. Those who appreciate the fact that trading commissions have never been lower, that market liquidity has never been better and, oh yes, that stock prices have never been higher. Based on these, it looks to me as if it’s actually rigged in our favor.
Short answer…our stock market is not rigged and you don’t need to be worried that a bunch of super computers are taking advantage of you.
The fact is that some HFTs will push the envelope. But, as Art Hogan, chief market strategist at Wunderlich Securities, says, “there’s a world of difference between ‘rigged’ and structural inefficiencies.” All of those things can be addressed and they are being discussed now. The bigger concern is the complexity and operational risks of the entire global market. Technology is almost always ahead of the regulators so we have to ensure the exchanges and other venues work together to provide the needed transparency.
The automated, speed of light high frequency traders have cost major Wall Street firms a ton of money. However, the effect on you is pretty dang small, in my view. This HFT world usually involves just fractional moves in stock prices; not the big moves investors like you want to secure.
Michael Santoli said this week that, “the noise and outrage surrounding the HFT issue far exceeds the apparent inefficiencies or abuses in the system.” HFT is the essence of short-term trading – not investing. And, as my buddy Jim Cramer said, “I’m not interested in competing for pennies a trade. I want big gains and the only way to get them is with powerful, longer-term themes.” They’re both right.
If you would like help in creating a strategy today to identify these themes or, if you’d like a no-obligation review of what you’re doing, please email or call me now to talk about it.
Cheers!
Mike
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