High-frequency trading (HFT) is a technique used by certain brokerage firms to get in and out of a stock in a fraction of a second. Main stream media is landing on this like flies to what my dog Max leaves behind and I have to clean up. Is HFT really something to worry about or not?
What exactly is high-frequency trading?
As I said, some brokerages use heavy duty computers with lightening quick communication lines to trade ultra-fast. Because of their technology, they see orders coming down the pike or important news information a few milliseconds before you or I do.
As a result of this razor thin advantage, they slip in an order to buy or sell (or buy AND sell) before we have the time to take a sip of coffee. They are delighted if they make even a fraction of a cent per share on the trade. So they buy a stock at $1.00 and sell it at maybe $1.0001 for example. It’s not a lot of money per trade. But if you do this millions of times a minute the profits pile up.
What’s Happening In The industry?
According to the New York Times, high frequency trading profits are going to come in at around $1.25 billion this year. That is serious cabbage but it’s down 35 percent from last year. And it’s almost 75% lower than the $4.9 billion the industry raked in during 2009. As s a result of this shrinking opportunity firms that use these strategies are shutting down or cutting staff according to the Times.
5 Reasons Why High-Frequency Trading Is In Decline
1. As more players got wind of the easy money machine HFT was thought to be, more competition entered the field. That put a squeeze on profits.
2. Trading volume on the exchanges has dropped significantly over the last several years as well. This makes it tougher for fast traders to get in and out of positions.
3. Mutual funds have gotten wise to these tricks and are either using HFT or trading off the traditional platforms. (This is a more serious problem and one I’ll be writing about soon.)
4. Every effort to shave another millisecond off the time it takes to trade becomes more and more expensive at this point. The easy and cheap technology has already been deployed.
5. International regulators are eyeing these activities closely. They pose a threat to this business and that keeps companies from investing in the technology too.
Does HFT Hurt Small Investors?
There are mixed feelings about this. Many studies point to how this practice helps reduce the cost of trading for the small investor. On the other hand, there is a real risk that this technology can exacerbate a market decline.
On May 6, 2010 there was a “flash crash”. The market lost 1010 points (9%) at 2:45 PM and recovered within minutes. The SEC concluded that this was caused by one sale of $4.1 billion in futures contracts by one mutual fund company in order to hedge its bets.
The firm in question never meant for the crash to happen but that one trade triggered it and it was all because of HFT. As a result of that event, the Chicago Federal Reserve suggested that several controls be put in place to curb HFT. Those measures are still being debated.
High Frequency Trading – The Bottom Line
Based on the research I did, I don’t think it’s fair to blame the companies that use this technique on “rigging” the market. There isn’t any evidence of this. They do have a technological advantage but they pay for it. It’s not illegal.
In some cases, traders are able to pocket profits that you or I couldn’t – unless we buy mutual funds that use this technology (and nobody is stopping us from doing so).
The real threat is that this activity could indeed trigger market mayhem but I don’t think that should worry long-term investors. Here’s why.
Any market meltdown caused by technology will likely self-correct really fast. That’s because if shares drop artificially these super-fast/smart computers will recognize it and buy shares right up. That’s what happened back in 2010 and it makes sense.
And if the market itself isn’t enough to take care of your concerns, there is always the government. It is very likely that the SEC will put controls in place that limit the ability of programed high frequency trading to crash the market.
Are you concerned about High Frequency Trading? Why or why not?