The Dow Rises as High-Frequency Trading Comes out of the Shadows

The Dow Jones moved higher as the FBI opened an investigation into the shadowy world of high-frequency trading.

Apr 1, 2014 at 12:30PM

The Dow Jones Industrial Average (DJINDICES:^DJI) was up 62 points at 12:30 p.m. EDT as news of an FBI investigation into high-frequency trading dominated business headlines.

Traders W Computers

Photo Credit: Rafael Matsunaga.

High-frequency trading dominates the investing conversation 
Companies involved in high-frequency trading use complex computer algorithms to buy and sell stocks at extremely high volumes for extremely short periods of time. The computers take advantage of tiny price movements and aberrations, collecting profits of pennies (or less) per trade.

The high-frequency traders look for a price mismatch or a permanent price movement driven by fundamentals such as a data release or world event. Using speed as the ultimate advantage, the firms buy or sell the stock in question before anyone else.

In essence, because of their speed advantage, the traders can perfectly time highs and lows in the market on a microscopic scale. The process works because of volume -- while the net of each trade might be minuscule, execute that trade a million times and the cash adds up. A 2013 study estimated that these firms earn $0.43 for every $10,000 traded. Thin margins, but again, it adds up.

In theory these firms add liquidity to the equity markets by trading so often and at such large volumes. For the typical retail investor who buys or sells only a few times a month or year, the high-frequency traders don't really do any harm.

The greater risk for everyday America is if something goes wrong with the software, causing the markets to go haywire as computers buy and sell stock at incredible volume. In the worst-case scenario, trillions of dollars of wealth could be lost in the blink of an eye. Billionaire Mark Cuban and others have called this risk "unquantifiable," and reference the Flash Crash of 2010 as an example of just how quickly things can go wrong.

Enter Johnny Law
The FBI entered the picture after high-profile opponents of the business began crying foul. Cuban, author Michael Lewis, and others have all been very vocal, going so far as to call the entire market rigged.  Its hard not to raise your eyebrows when these firms' financials show that in the daily business of trading stocks, they've only had a single losing day in the last 1,238 trading days!!

The investigation will seek to determine if the high-frequency trading firms are using their technological and speed advantage to trade on information before it's available to the public -- you, me, and the Wall Street firms that have traditionally been the source of liquidity in the market. The FBI thinks that this advantage may constitute insider trading.

For you and me, the outcome of this investigation will not likely impact our investing lives all that much. But for the market makers such as Dow stalwarts Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM), the impact could be huge.

For the typical retail investor, the fact that a high-frequency trading firm is buying the stock a moment earlier and then selling it to you for a penny more now isn't a significant price change. But for Goldman or JPMorgan, businesses that execute millions of trades every day, those pennies add up very quickly. Literally hundreds of millions of dollars are at stake. 

In the short term, this is a story about how Wall Street is yet again using new and extremely complex methods to make a buck. But in the long term, the outcome of this investigation could be another major shock to Main Street's belief in the markets as a safe place to invest. 

My advice is to keep it simple. Buying the stock of companies you understand and believe in for the very long term will make high-frequency trading meaningless to your investing success. That said, if you own the stock of a Wall Street bank such as Goldman or JPMorgan, this investigation could result is a nice boost to trading revenue, and ultimately profit!

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Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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