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High Frequency Trading: is it happening to you?
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Can you ride the wave?
In a July article entitled "More about Investing" I described how the investment markets and operations are changing and how I felt about those changes.
It appears I was a little off-base with that article. Not really off-base but more like behind the times. Market strategies have changed again, and you need to know about it. (By the way, they will ALWAYS change so if you can't keep up with it, make sure your advisor can.)
In the meantime, large Wall Street Financial Firms are reporting fantastic quarterly profits. In a recession. A BAD recession.
Turns out those profits are related to those new market strategies.
Computers have taken over the markets. Yes, we already KNEW that but in the last few years these electronic devices have REALLY taken over the markets.
In the past trades were made by humans and stability in the markets was ensured by the use of "market makers". Simply stated, market makers made sure there was a buyer to MATCH every seller, or a seller to MATCH every buyer. This artificial "coupling" of buy and sell made the markets "liquid" and any time you wanted to sell, SOMEONE would always buy. To accomplish this feat market makers "amassed" orders and processed them as fast as possible.
Computers have taken over the function of the market makers. The electronic programs are faster, nimbler, and more accurate, and (in theory) less prone to "mistakes". One mistake is when a wrong order is entered. It rarely happens, anymore. Another "mistake" is when a market maker KNOWS there are pending orders for a stock so he PERSONALLY buys the stock at a lower price to match HIS stock up with the incoming buy order. Since the market maker has "early" knowledge of the order, this process is called "front running" and it is ILLEGAL with very serious penalties. NO market maker can use his or her knowledge of PENDING orders for personal gain and it almost NEVER happened.
But then we have the computers and their HIGH FREQUENCY TRADING, or HFT. Several companies have entered the markets using their computer trading platforms as "market makers" and these platform work a little differently than the human market makers.
For example, let's say a large institution (like a Pension Plan Fund from North Carolina) will want to enter the market and buy stock. Rather than enter one VERY large order that will skew the market, the Pension Plan will enter smaller, pending orders to be processed at different times. (This, by the way is called "iceberging". Can you see why?) This lowers the "buy" pressure on the markets and keeps prices from fluctuating wildly.
Enter HFT: some software programmers have developed software that can "FIND" these pending orders in milliseconds, buy the target stock at a lower price, and resell it to the Pension Fund. It all happens in a matter of seconds and yields risk-free profit for the company that owns the Ultra-Fast HFT computer and HFT software. Simple example: the Pension Plan places 10 orders for 10,000 shares per order of XYZ at the current, 10:01:01 am price of $1. HFT software "probes" system computers and finds these pending orders. At 10:01:02 am the price of XYZ falls to $.97. HFT computers buy up XYZ and when the Pension Fund orders are executed at 10:01:03 am and later, the HFT computers sell their XYZ shares to the Pension Fund at $.99. On the surface everyone wins, yes? The Pension Fund paid a LOWER price of $.99 and the HFT computer owners made $.02 a share in milliseconds. Insert "Wall Street Financial Houses" as the HFT computer owners and you can see where their record profits are coming from.
Yes, it IS "front-running" and should be illegal. But it is going on every day. Aita Consulting of Boston MA, reports that 73% of all trades in 2009 are being done by HFT.
How does it affect you? Hm. If the Pension Fund had bought XYZ at the market price at the time of the order, the Pension Fund would have gotten the shares for less, made more when the shares appreciated, and been in a better financial position. Did it do the economy or the country any good for a super-fast HFT computer to allow the Wall Street Financial House to reap a risk-free 2 cent-a-share return? Is this type of front-running really illegal? Or even bad?
Of course it's bad. Next time you place your order for XYZ at $1 a share, and the market price falls milliseconds before your trade is executed by your broker, the final price you settle for might INCLUDE the profit margin an HFT computer has "built-in". Is that good for anyone but the HFT computer owner? No. Does it add ANY value to the market? No. Does it make the market even MORE like a big, video game? Yes. Does it mean the big, Financial Houses have an unfair advantage in this game? You decide.
And, AND HFT is increasing market volatility. Currently, that volatility is headed UP. What will happen when it heads DOWN? (PS: the HFT trader makes money in both directions.) Remember last year's market crash? Many opine that HFT had a lot to with the speed and depth of the market decline.
So ask your trader, broker, advisor if he/she knows about HFT, and if the funds he is putting you into are "players", and then ask his or her opinion of buy and hold in the current market environment.
Oh, and caveat emptor.
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