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What's Wrong With a Little High-Frequency Trading?

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The headline on a new study from economist Andrei Kirilenko is being promoted as something like "High-Frequency Trading Hurts Small Investors," but the title is misleading. While high-frequency trades now account for close to half of all the trades made during any given day, I don't believe they pose a meaningful threat to the small investor. Kirilenko relies on a flawed premise to get to his conclusion, and succeeds only in adding more fuel to an already roaring fire. But while we sit and warm our hands, we distract ourselves from the real challenges of investing.

Whose side are you on?
When I talk about hurting investors, I'm really worried about the small, non-professional investor. There have been other claims that institutional investors are hurt in other ways, but today we're going to focus on the little guy -- and he's got nothing to worry about. That might seem counterintuitive; after all, we're talking about going up against huge teams of number-crunching machines that execute multiple trades every second. But the success of those trades doesn't mean the little guy loses.

One of the keys to Kirilenko's new report is that he thinks of the market as a zero-sum game -- in order for one side to win, the other has to lose. But I think he's got it wrong. The market isn't zero-sum, and high-frequency trading isn't cheating. In fact, we're all winning the lower transaction cost game thanks to the infrastructure and efficiency of some of those big high-frequency businesses. The systems that companies like Knight Capital (NYSE: KCG  ) -- which lost close to $450 million in a trade gone awry this year -- employ have pushed costs down for retail investors, and their research has helped make general transactional software more efficient.

The bad rap is hard to beat
So it seems like, as small-timers, we'd be applauding the high-frequency firms. Yes, things do go wrong, just like with any other trading system. High-frequency trading creates a lot of noise in the marketplace, and some of that noise may be intentional. One study found that occasionally, less than one order out of 100 sent will actually be acted on, with the rest of the orders being canceled. But traders say that the excess orders are just market feelers, which gauge the liquidity of stocks and give the algorithms a more accurate understanding of pricing.

No matter what all those extra orders are meant to do, sometimes they have dire consequences. When Facebook (NASDAQ: FB  ) IPOed earlier this year, the sheer volume of orders temporarily shuttered the market, causing the exchange to have to halt trading. But high-frequency trading didn't make Facebook a bad company or a good company. It didn't affect Facebook's long-term prospects, and it didn't have any impact on the small buyers who buy good companies -- investors in the traditional sense.

Maybe what investors really don't like is that high-frequency trading makes the market more unstable. We all remember the so called "flash crash" from 2010, when the Dow dropped 9% in mere minutes, and then regained the lost ground just as fast. While that incident hasn't been strictly tied to high-frequency traders, there is no doubt that the problem was exacerbated by their activity. But, while things may happen more quickly, volatility doesn't actually increase in the market due to high-frequency trading. A study from the U.K.'s Foresight Project, found that high-frequency trading didn't increase overall market instability.

Everyone loves a good excuse
So if we're not worried about high-frequency trading causing market volatility, and we don't think that we're being cheated, and if the systems that the traders use actually make things cheaper for us, why can't we get on with our lives? I think it's because those anonymous algorithms make us feel better when we make mistakes. We can point to hedge funds, or big banks, or high-frequency trading as the thing that messed it up for us. We can try to ignore that management was horrific, or that the product had no competitive moat, because the stock fell due to some completely unforeseen force.

But excuses don't pay anyone's bills -- except political speech writers. Instead, let's focus on what we should be doing in the first place. Let's follow the advice of a low-frequency guy: Warren Buffett. Always a giver of sage advice, Buffet famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Blaming high-frequency trading for our inability to recognize a wonderful company and a fair price doesn't make us better investors. As usual, it pays to stick to what we know best, and ignore what we can't control. In that vein, Morgan Housel's 9 Financial Rules You Should Never Forget makes for a reassuring read, no matter how good you think you are.

Read/Post Comments (3) | Recommend This Article (2)

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  • Report this Comment On December 07, 2012, at 12:29 PM, Lordrobot wrote:

    Sorry but the premise of your arguments are silly. Before the markets had computer trading and HFT, stock holding and trading was rather limited to the dark pool players like Buffett.

    From what I can gather about Buffett is that his grandfatherly act is more akin to preservation of the rooster in the hen house. I am sure he would prefer a world with lesser competition than one with more.

    The reality is that without HFT, you could not sit at home in your underwear trading stocks on US and Global markets. So its a wonderful thing for everyone in the world and it is only at its infancy.

    It will go global and eventually markets will be opened 24 7. I am very bullish on KCG and the possible GETCO merger.

    I loved your remark that "Everyone loves an excuse.." exactly. A trader is a genius if he makes a few bucks and it is always some crook on the other end when he loses.

    But there is vastly more to it than claiming Buffett is the counterweight of HFT; he is most assuredly not. As with his army of Tax Attorneys which he employs while decrying that he is not paying enough tax, he does more than his fair share of HFT and dark pool deals. Buffett really pushes his grandfatherly persona to the point of nausea. He has never been a generous man compared to less friendly guys like Icahn. He has spent much of his elder life pushing money into his children's charitable foundations which they run at huge salaries and to Gates Foundation.

    Then he pushing the idea of Billionaire giving. Guys like Kirk Kekorian give money to many causes and Kirk never allows his name to be associated with the gift. There are no hospital wings named after Kirk though he has bought them.

    Using Buffett in your argument is a fallacy argument. I think you might find it easier to understand Buffett if you replace his head by that of a Great White shark. That is closer to his true internals than Mr. Rodger's Grandfather. ... "Its a lovely day in the neighborhood..."

  • Report this Comment On December 07, 2012, at 1:24 PM, XMFRedRam wrote:

    Thanks for reading.

    I'm not sure how using Buffett is a 'fallacy'. It seems like, even if everything you claim about him is true, it's still fair to use the public persona of Buffett as the opposite end of the spectrum.

    I'm not asking anyone to love the guy, just to see that there is no reason to worry about HFT as long as you invest in good companies at fair prices.

    Cheers, Andrew

  • Report this Comment On December 07, 2012, at 3:44 PM, sceeto wrote:

    Wall Street High Frequency Traders May Have Finally met Their Match Thanks To New Groundbreaking Software by High Frequency Trading expert Carl Weiss

    High frequency trading has been causing havoc worldwide for a few years now leaving the average trader frustrated and wondering how to compete against these huge trading houses with super fast computers and trading bots.

    Thankfully now at least the HFT's and their bots can be tracked in real time by anyone.Have a look at the way the bots were in action a few weeks ago during the US Presidential election courtesy of Carl Weiss from sceeto

    As you know High Frequency Trading and these type of algos as a matter of fact are responsible these days for more than 70 to 80% of all the daily US volume. hfts have been quote stuffing, i.e placing massive buy sell orders within milliseconds for a long time now. sceeto is one of the first small companies anywhere in the world that tracks the hft's in real time across various markets. Have a look for yourself ,Carl Weiss has done numerous videos on these algos. The chief software developer of sceeto he has for a decade tested to come up with software designed a system to sniff these out and try to at least again level the playing field a bit for the ordinary investor.

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