"These guys are not stealing dollars, they're stealing pennies… it's like paper cuts instead of first-degree murder." - Eric Hunsader, founder of Nanex
The term high frequency trading ("HFT") has a negative connotation to many investors because it represents a highly sophisticated insider's game that benefits Wall Street at the average investor's expense. This sentiment is not unfounded, but it also doesn't fully capture the entire story. Before getting into the positives and negatives of HFT to the average investor, we must first understand HFT and how it works.
HFT is an algorithmic, computer based trading approach that tries to make a very small profit over an extremely short period of time. The speed of execution for HFT transactions has increased exponentially over the past decade. In a report issued by the Bank of England back in 2010 entitled Patience and Finance, the author quantifies exactly how much faster trades are executed today versus the turn of the 21st century:
A decade ago, the execution interval for HFTs was seconds. Advances in technology mean today's HFTs operate in milli- or micro-seconds. Tomorrow's may operate in nano-seconds.
Unlike investors, most HFT firms only trade intra-day so they are completely out of the market by the close of trading each day. Profit is made on the difference between the purchase and sale prices (e.g., buy low, sell high). The hold period for an HFT trade can often be less than a second, which is why speed of execution is essential for HFT participants where the fastest execution wins and coming in second is the same as coming in last. This is why hundreds of millions of dollars have been spent by some firms investing in an infrastructure that will allow them to execute milliseconds faster than the rest of the market, including a $300 million fiber optic cable linking New York to London for the purpose of shaving 5 milliseconds off trade executions..
Most HFT trading is done by market participants trying to skim fractions of pennies off of millions of transactions each and every day. Think of a group of very smart people using really expensive computer equipment to develop a system that can predict and profit from the movement of financial securities over very short periods of time. Based on the speed at which these computers receive, analyze, and transmit data, they are able to create an edge in the market. Receiving information a couple of milliseconds before the rest of the market allows HFT programs to exploit pricing inefficiencies and make a profit. In order to always be half a step ahead of the rest of the market, HFT programs are constantly bombarding the market with trade orders to extract information.
This video put together by Nanex, a data delivery company founded by HFT market observer and watchdog Eric Hunsader, is an example of HFT in action. It shows the number of orders placed on Johnson & Johnson (NYSE:JNJ) stock over a half of a second time frame on a single trading day in May of last year. The nodes represent different exchanges and the colored dots represent orders that are being transmitted. The entire video is almost six minutes long, which means that each second in the video represents around 0.0001 seconds in real time. During the half of a second represented in the video, over 1,200 orders were placed and 215 actual trades occurred.
This amount of activity creates a lot of noise for other market participants, but isn't necessarily harmful to the market. Since HFT firms are executing millions of orders a day, they are adding liquidity to the market. The additional liquidity is a benefit to investors who can thereby transact at tighter spreads (price improvement) in less amount of time. Unfortunately, this added liquidity is typically present when markets are behaving "normally" and it quickly dries up at the onset of a fear induced sell-off like we saw last month in the S&P 500 (NYSEARCA:SPY) with the "Twitter crash" or the far more infamous "flash crash" back in 2010. Some market pundits have also pointed the finger at computerized trading systems for causing the sharp two day sell-off in gold (NYSEARCA:GLD) prices last month. Several European countries have considered banning HFT due to these types of episodes, which increase volatility (NYSEARCA:VXX) and damage investor confidence. The International Organization of Securities Commission released a report in 2011 pointing the finger at HFT as one of the culprits in the 2010 flash crash:
Whilst developments may have helped foster innovation and choice or improve market efficiency and liquidity, these same developments may also have had negative effects. For instance, whilst algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010.
The other issue with HFT is whether or not it gives an unfair advantage to market participants with deep pockets like many hedge funds and investment banks. The consistent profits HFTs have been able to generate over the past several years may be the most damning evidence of the insider information allegation. In a 60 Minutes report on HFT, hedge fund manager and HFT trader Minoj Narang stated:
We've had two or three days in a row where we lose money, but we've never had a week so far where we lost. We've never had a month that was a loser for us.
It would be hard to explain this type of track record based purely on superior investment acumen. That being said, increased competition in this space over the past couple years has led to fewer opportunities for HFT traders corresponding to lower profits, so maybe the insider advantage was short lived.
So what does all this mean for the average investor? Well, if said average investor is maintaining a long-term focus and acting more like an investor than a short-term trader, the answer is that it has very little impact. Some might even argue that it creates opportunity for contrarian or value investors to take advantage of temporary market dislocations brought about by computerized trading. If HFT is shown to be a form of insider trading, then it should be banned from the market, but in the meantime, the impact of HFT to the individual investor is minimal to say the least. The market price of securities over short time horizons can vary greatly and perhaps HFT shops are adding to the noise, but over long periods of time, fundamentals will drive returns. This idea was summarized beautifully by the father of value investing and Warren Buffett's mentor Benjamin Graham when he said, "In the short run, the market is a voting machine but in the long run it is a weighing machine."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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