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High Frequency Trading Trading: Harmful for Fundamental Investors, With ONE Exception...

|Includes:EXC, The Procter & Gamble Company (PG)

As a fundamental investor (albeit, one who "trades around" his positions and uses technical analysis for entry and exit points), I thought I should learn a bit more about how I might be affected by the High Frequency Trading (HFT) about which we hear so much these days. Thus, I attended last week's IQPC Algorithmic Trading Strategies Summit in New York, and here, in layman's terms (and when it comes to HFT I'm absolutely a layman, so "corrective comments" are welcome), is a bit of what I learned...

First, we should differentiate between high-frequency trading and algorithmic trading. What's generally referred to as algorithmic trading uses computer programs to automate what was traditionally done by traders manually. The most oft-cited example of this at the conference is when fundamental investors use software to break up large orders into a number of smaller orders so as not to excessively move the market price of a stock; meanwhile, short term traders use their own algorithmic software to try to sense when those programs are at work, and then attempt to front-run the orders. While this is extremely frustrating for long-term institutional investors (as it forces them to pay more for a stock-- or sell it more cheaply-- than they otherwise would), it's really just a modern, computerized form of "tape reading", which is pretty much what folks such as Jesse Livermore were doing 90 years ago. Fortunately, the individual investor is unlikely to be affected by this, as his or her orders are likely to be small enough that they don't show up on the "radar screens" of those short-term traders. (One important exception to this, though, would be trades executed by the portfolio managers of one's mutual or pension funds.)

Meanwhile, all fundamental investors are likely to be negatively affected by "high frequency trading", especially a form of it called "latency arbitrage". This involves co-locating a server next to the market's centralized price-reporting data center in order to see the latest bid and offer prices a fraction of a second before most other market participants can see them. The HFTs then jump in front of those existing bids and offers with purchases or sales of their own, thereby causing the other participants to pay more for their shares (or sell them more cheaply).

Occasionally, these HFTs may even insure that they "get the order" by providing a tiny bit of price improvement, which they more than make up for by receiving rebate payments for routing their orders to specific stock exchanges. However, this "price improvement" is generally so negligible (you may have seen this when bidding to buy a stock for, say, $3 a share, and instead having it sold to you for $2.999) that it isn't worth the frontrunning that will impact you when you're the seller whose trade doesn't go through, thereby forcing you to lower your sale price substantially more than the 1/10 of a penny you may have saved when you bought those shares. As annoying as this problem is, though, there may not be much technically that can be done about it. For instance, if co-location were banned, the HFTs would simply rent a building on private property next door to the exchange's servers, and thus they'd still be able to see the pricing information before it's seen across town (much less across the country).

Fortunately for fundamental investors, though, in a sort of bizarre way there's one piece of very GOOD news that came from this summit: many of the experts believe that more "flash crashes" are inevitable.  Yes, you read that (seemingly insane) sentence correctly, and let me illustrate why with a personal example...

I manage several retirement accounts for family members, and for those accounts I tend to buy primarily the kind of dividend paying, blue-chip stocks that you'd want  to see in such accounts. However, since the March 2009 lows, many of those stocks have run up to prices much higher than I'm willing to pay for them in light of my rather bearish overall perspective on the economy. Thus, since before the May 6th "flash crash" I've had a number of "good 'till canceled" orders in place for those companies at much lower than current prices, and on the day of that crash a couple of them were filled, purely because the computers went haywire. So, we picked up some "$63 pre-crash" Proctor & Gamble (NYSE:PG) at $53 (then sold it the next day at $63, where I again thought it was overvalued) and some "$42 pre-crash" Exelon (NYSE:EXC) at $38 (it bounced back later that day to $42, and we still hold it today).

So, if you're a fundamental investor, I suggest that you enter a whole slew of bids for stocks you want to own at prices at which you want to own them (and, by the way, never enter automated sell-stop orders!), and then sit back and hope for "flash crashes" two, three, four five and six, because if they happen, you'll have a chance to make far more money from those no-common-sense computers than they're stealing from you in the meantime.

Disclosure: Long EXC

Stocks: PG, EXC