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News flash! High-frequency trading (HFT) is happening!

The "60 Minutes" piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even "60 Minutes" has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently, the FBI is now suddenly concerned over this "latest blemish."

Again, this is hardly new. Here is the record of Google search activity of the term "high frequency trading."

(click to enlarge)

So why is it that, for years, most of the world knew about HFT and yet no one did anything about it? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?

To put it simply: this is a crime where it isn't clear anyone is being hurt, Lewis' panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let's be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as "the big banks buy the stock and then the retail investor buys it 5%-10% higher." This would be a problem, if that's what was happening. But it isn't. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from - if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That's not a loss to you - it's a gain.

High frequency traders aren't just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see "What Do We Know About High Frequency Trading?" from Charles Jones of the Columbia Business School).

So, if you're being ripped off, it's far more likely that you're being ripped off by commissions than that you're being ripped off by the robots.

But let's suppose that the robots do push prices up 5% higher than they would otherwise be. Either that's the right price to pay... in which case they made the market more efficient by pushing it nearer to fair value... or it's the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that's you, then the robots aren't the problem - you are. Stop giving them a greater fool to sell to, and they will lose money.

Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than "you're getting ripped off by robots": yes, the market is full of very, very smart people. And yet, average returns cannot be above-average! This means that if you don't know everything there is to know about Tesla (NASDAQ:TSLA) and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don't have to have inside information to beat you - they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don't know everything there is to know about TSLA. I am the sucker at that table.

Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren't always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of "client first" - although that doesn't mean the culture is "me first," it means the client's needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.

And I don't really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.

The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size - often billions - on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.

Source: Tempest In A Microsecond