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Apr 15, 201412:09 PMFinancial Perspectives

with Michael Dubis, CFP

What you need to know about high-frequency trading

(page 1 of 2)

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 (21st, not 20th), 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)

Jun 25, 2014 12:37 pm
 Posted by  Anonymous

Individually should I care that I may have bought 100 shares of IBM at a half penny more than what had been in the market, had I been using a sooper dooper computer? Does the HFT add more value through liquidity than it costs, at least to the individual?

What is your point Mike?

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It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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