That age old axiom, "Just because you're paranoid don't mean they're not after you," may ring true for many retail investors where High Frequency Trading (HFT) is concerned. Investors are already scared stiff about the fiscal cliff in the United States, government bankruptcies in Europe, unrest in the Middle East, and then there is that psychological hangover from the Flash Crash a few years ago. The Flash Crash is where the Big Board tanked 1,000 points in a matter of minutes and was caused by high-speed trading robots, part of the potent underlying force of HFT.
Recently, Crown Business published Dark Pools by Scott Patterson, which takes us through the 20 year history of High Frequency Trading. I couldn't put it down. It's a page turner that reads like a novel. You can almost consider it the sequel to his first book, The Quants, which gave us the background of algorithmic trading, and its technological assault of the stock exchanges.
What was once a cottage industry started by members of the technorati is now the dominating force on the exchanges accounting for 70% of all movement of buying and selling securities. Transactions are now done at microsecond speed with wafer thin margins. A literal cash machine for HFT firms who make money daily at the expense of not only the retail trader but the whales in the large pension plans and mutual funds.
Technology-wise, being a quant and a high frequency trader are almost the same, but there is a slight difference. Quants attempt to beat the markets via algorithms, and these algorithms are solely based on technical analysis. Fundamental analysts need not apply. High Frequency traders utilize souped-up algorithms fighting other algorithms. It's like a quant on synthetic enhancements. This is not a level playing field. But you've got to ask yourself, since when has Wall Street ever been a level playing field?
High Frequency Traders are plugged in and on the world stage as the labyrinth of fiber optic cables strewn from trading floor to trading floor spans the globe. Those market makers on the floor of the Big Board are a dying breed. It's all about the speed of the transaction. HFT firms collocate their servers near the big server farms of all of the major stock exchanges to gain a split second advantage over the competition. Some HFT firms use nitrogen-cooling systems to overclock their chips, a technique used by hardcore computer gamers to boost speed. Individual traders don't stand a chance.
HFT's early incarnation was an altruistic ideal to give individual investors the opportunity to purchase shares with minimum commissions. With discount brokerage houses offering trades for under $10, they've accomplished their mission. In addition, they've also injected an enormous amount of liquidity into the system. When you execute a trade, it's almost an instantaneous transaction. Even with a market order you are going to get your price as equities exchange hands in nanoseconds - unless there is another flash crash. The probability of another more severe catastrophic event is high according to the author.
From the vantage point of Mr. Patterson, the "legit" business of High Frequency Trading is in need of some sort of government scrutiny to lessen the impact of another Flash Crash. He is not alone in his assessment. In 2011, Jim McTaugue wrote Crapshoot Investing which came to the same conclusion. More recently, Sal Arnuk and Joseph Saluzzi penned Broken Markets, which also concurred. Both books are about High Frequency Trading.
Calling the stock market a rigged casino is like calling a car an automobile, but it is a game of chance. You calculate your probability for success, and place your bets. Some people will have more advantageous outcomes because they have insider information. Front Running, where a market maker illegally trades for his own account with proprietary information, is now solely done via electronic algorithms. The little guy always gets shafted.
A great book for investors who want to be informed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.