Who Are the Stock-Trading Robots Eating Alive?

Are stock-trading robots picking your pocket?

That seems to be the media's conclusion when it comes to the impact of high-frequency trading operations. For those who aren't up on the lingo, high-frequency trading, or HFT, refers to funds that try to make money by making ridiculously voluminous, lightning-speed trades in order to capture pennies at a time that they hope will add up to millions. Sometimes this trading is guided by Ph.D.-derived strategies based on esoteric correlations between stocks or other assets. At other times, it looks for simple, small-time arbitrage opportunities that can be had because of the speed at which the computers trade.

In the wake of the blunder at Knight Capital (NYSE: KCG  ) , there are some very leery eyes glaring at everyone in the business of HFT. That shouldn't be surprising, since Knight is a key player in that arena -- not only does it facilitate trades for its clients, but it also makes money by doing some quick share-flipping for its own account.

As the financial media like to appeal to a mass market, there's been a push to explain to retail investors why HFT is bad for them. Indeed, they've claimed, because HFTs can trade so much faster than you and have quicker access to data, they can jump in front of your trades and pick your pocket for a few pennies per share without you ever being the wiser for it.

I've talked to industry data wonks who have assured me that this sort of thing does happen -- particularly when we're talking about sloppy investors that use market orders or leave trailing-stops hanging around.

However, what you don't hear much of is the likelihood that some profits for HFTs don't come from fleecing retail investors at all, but, rather, by eating each other alive.

We only have to go back to fall of 2011 to recount the closure of Goldman Sachs' (NYSE: GS  ) Global Alpha fund, a pioneer in the quant/computer-trading space that was started with $10 million by hedge-fund hotshot Cliff Asness and peaked with as much as $11 billion under management. But the one-time top-o'-the-heap hedge fund started to get hammered. It lost 23% in one month in August of 2007. It stumblingly tried to regain its footing, but experienced further losses, including a 12% loss in 2011, a year when the Dow Jones (INDEX: ^DJI  ) was up more than 5%. The loss that year pushed Global Alpha to close its doors.

Also in August 2007 -- which was a bloodbath of a month for quant funds -- Morgan Stanley's (NYSE: MS  ) quant traders managed to lose $390 million in a day. AQR Capital Management, the $40 billion-plus money manager built by Asness when he left Goldman, watched its multibillion-dollar flagship quant fund lose 15% through the first month and a half of 2008.

But these are giant operations. What of the small, start-up funds with poor strategies or computing horsepower that isn't quite up to snuff? They could get chewed up, spit out, and close up shop -- a few million dollars poorer -- without the media taking much notice.

What the implicit assumption seems to be is that somehow, high-frequency traders are always on the right side of the trade. It's a somewhat understandable assumption since in the shadowy world of computer-driven hedge funds and trading firms, only the ones that have been extremely successful are easily identified. It's also easy to paint a picture of the theoretical HFT shop -- that lawless office hidden in some dark corner where nefarious geniuses hunt retail traders like so many endangered prairie bison.

But as Knight Capital and Global Alpha underscore, high-speed, computer-based traders aren't always on the right side of the profit/loss ledger. It could be poorly written software, mistaken correlation assumptions, or a sudden unanticipated change in the markets (which got the blame for the 2007 quant-fund trashing). The bottom line is that when one computer-driven-trading operation is profiting, the account losing on the other end may not be a poor, defenseless retail trader but another soulless metal box.

Computer-driven trading, and high-frequency trading in particular, is changing the landscape of the financial markets. In some cases it's for the better. In other ways, not so much. But, if we're going to push for reasonable regulations, then it's important to get a good understanding of what's really going on rather than make spurious conclusions simply because it's an easy sell for mass-market readership.

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Fool contributor Matt Koppenheffer owns shares of Morgan Stanley, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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  • Report this Comment On August 13, 2012, at 8:02 PM, prginww wrote:

    HFT's are gaming the market like a Las Vegas casino. They do not buy or sell based on the value of the company, but rather if they can nip some cash out of the bucket.

    By the way, you did not mention that NYSE pays frequent traders for the volume of trades! WTF?

    There is a bill in congress to place a 0.3% tax on trades. I can afford that small amount, plus it will stop many HTF trades because they make less than 0.3%. Simple. Please support this bill.

  • Report this Comment On August 14, 2012, at 1:02 AM, prginww wrote:

    "They do not buy or sell based on the value of the company, but rather if they can nip some cash out of the bucket."

    Yes, this is true, but how does that amount to "gaming the market like a Las Vegas casino"? This isn't a situation of "the house always wins". The writer has given some pretty good examples of HFT/quant funds getting demolished. They're not always successful at "nipping that cash out of the bucket"...looking at the given examples of failures, it would seem that they are playing a risky game more akin to "picking pennies in front of a steamroller".

    "By the way, you did not mention that NYSE pays frequent traders for the volume of trades!"

    I might be off on this, but with market makers making more money with higher trade volume, don't the NYSE payments to frequent traders amount to something of a rebate and incentive?

  • Report this Comment On August 14, 2012, at 1:23 AM, prginww wrote:

    The chart and article are misleading. All it shows is traffic over the stock trading internet. Of course it has low activity when no one (thing) is trading.

    Robo-trading has some effect, evidently not the subject of this article. But the effect appears to be unknown except in our imaginations.


  • Report this Comment On August 14, 2012, at 7:44 AM, prginww wrote:

    Trades conducted in "dark pools" don't show up in exchange trading volume. I suspect that "dark pools" may be causing the typical investor more harm than HFT. If your broker makes your trade in a "dark pool" that offers them a better deal than the open market when it's convienent it may not be the best trade you could get. What's the real difference between trading in a "dark pool" and your broker just matching your trade with another of their customers and setting the spread to favor the broker.

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