High Frequency Trading: Is The Small Investor Getting the Shaft?

60 MinutesLast Sunday 60 Minutes aired a segment about high frequency trading titled: “Is The Stock Market Rigged?”  Since its airing many of our clients have voiced concern over high frequency trading, so I have decided to share my thoughts.

To be honest, I knew very little about it prior to the 60 Minutes segment, but I did quite a bit of reading on the subject this week, and I now feel better prepared to weigh in on the conversation.  For those readers who don’t know what high frequency trading (or HFT) is, here is a little background.

Over the last few decades, technology has allowed the financial markets to make bigger and bigger buy and sell transactions faster and faster.  Trades that used to be done with handwritten orders and ticker tape can now be transacted by supercomputers in milliseconds rather than in minutes.  As it has become easier to fill large stock trades more rapidly, a cottage industry has sprouted up that exploits this new efficiency: the high frequency trader.  The high frequency trader sees your order to buy stock at a particular price, but before your order gets to the stock exchange (in less than a second), the high frequency trader buys the stock ahead of you and sells it to you at a slightly higher price.

Think of HFT like this:  suppose you want to buy your girlfriend a dozen roses, so you call the florist and ask what the price will be.  The florist quotes you $24.00. You tell the florist you live 15 miles away, but you will drive right down to buy the dozen roses.  Unbeknownst to you, a high frequency rose merchant eavesdropped on your phone call with the florist.  Knowing your intention to buy 12 roses at $2.00 apiece, he drove down to the florist shop from his office only 2 miles away and bought the roses in the store for $2.00 apiece.  Knowing you are on your way to buy roses, he is willing to sell them back to the florist for $2.01 apiece. When you get to the florist, the florist tells you that since you called earlier, the price of roses has risen to $2.02 (the florist added a penny per rose for his trouble).  Although you are perturbed because you are paying more than you were previously quoted, you pay $24.24 for the roses and you surprise your girlfriend.

In this scenario, the high frequency rose trader knew you were interested in buying roses, so he raced to the florist before you and bought the roses at the price you wanted to pay. He also took the risk you would buy them back at a penny or two higher when you arrived to get your flowers.  If you had balked at the price increase, the florist wouldn’t have bought them back at $2.01 apiece, and the high frequency rose trader would have been stuck with an order of roses he really didn’t want or need.

That is exactly how HFT works in the securities markets.  Electronic trade orders can’t move faster than the speed of light, and the stock exchanges are located at different locations around the world.  When an order is placed electronically, those HFT firms located between the buyers of stock and the stock exchange where the order will be filled, can buy the stock you ordered at the price you were willing to pay a millisecond sooner. The HFT then sells you the stock at a penny or so higher per share.

HFT sounds pretty rude at best, and downright dishonest at the least; but, is HFT really a bad deal for the individual investor?  I guess the best way to answer that question is to ask “compared to what?”

When it comes to buying and selling stocks, liquidity is extremely important.  A market with sporadic buyers and sellers is an illiquid and inefficient market indeed.  As distasteful as HFT looks on the surface, it appears to help ensure a large number of buyers and sellers in the market, thus shrinking price spreads and increasing the odds an investor can sell their stock in the future.

Secondly, HFT seems to be more of a burden on large institutional traders than on smaller individual investors (See Morningstar article: “About That Rigging Claim.”  From my floral analogy above, you can see that buying a dozen roses at $2.00 apiece and selling to you for a 12 cents profit doesn’t sound like a smart way to strike it rich on Wall Street; however, when you are buying 100 million roses (or shares) and immediately re-selling them for a $1 million profit, you can see where HFT can be enticing.  To date, there doesn’t appear to be widespread HFT front-running on small trades entered by individual investors.

Since the dawn of civilization, there have always been stories of markets being “rigged” against the little guy (see Proverbs 20:23).  The mission of the U.S. Securities and Exchange Commission (SEC) is:  “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  When I look back over my 20 year financial career, the markets are fairer, less costly, and more orderly and efficient today than they have ever been.

In the past, small investors had huge barriers of entry that made investing difficult.  There were odd lot differential fees which made small trades extremely expensive, but today, few brokerage firms charge odd lot penalties.  Until 2001, stock prices were quoted in eighths of a dollar which increased price spreads (and trader profits), but now stocks are priced down to the penny, reducing price spreads and trading costs for all investors.  30 years ago there were almost no discount brokerage firms available to the small investor, but today there are numerous low cost opportunities to fit the needs of practically any interested investor.

Is the stock market rigged, like the 60 Minutes segment implies?  Yeah; probably, but it has always been rigged.  Even though middlemen have been skimming profits on stock trades at the expense of investors since the invention of the stock market, that hasn’t stopped millions of long term investors from accumulating vast sums of wealth.  In my financial career spanning two decades, I have observed substantially more money has been lost by NOT investing than has ever been lost BY investing.  In spite of HFT, markets today are less expensive, more transparent, and less sleazy than ever.  With the airing of the 60 Minutes segment, I suspect HFT will percolate to the top of the SEC’s list of Wall Street shenanigans to investigate.  But, I hope any regulatory cures they implement are better than the alleged financial ills of HFT.

Back to COCO Enterprises

2 thoughts on “High Frequency Trading: Is The Small Investor Getting the Shaft?

  1. Thanks so much for the great explanation. We had watched that 60 mins segment and found it interesting.

    • Thanks Sandy for the nice reply. I also found the 60 Minutes piece interesting. My only beef is it is the kind of journalism that frightens people unnecessarily. For the average person watching 60 Minutes, HFT doesn’t really affect them in a material way, but the segment gave the illusion is a real boogey man.
      I appreciate you reading our blog, as well as you comments.
      Sincerely,
      Joe Coco

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