There's Only 1 Way to Beat High-Frequency Trading in a Rigged Market

After watching Michael Lewis' high-frequency trading feature on 60 Minutes, it's easy to be disenchanted with the stock market. He highlights how high-frequency traders are legally "front-running" the market and outsmarting even the biggest, smartest hedge funds in the world.  

The New York Stock Exchange is now more of an icon than a center of market trading, which has been taken over by computers.

The government has taken notice as well and is taking steps to figure out what's going on. The New York Attorney General, the Commodities Futures Trading Commission, and the FBI are all investigating high-frequency trading, trying to figure out whether current practices are fair or even legal.

But the question I'm asking today is how it affects us as individual investors. The answer is complex, but there are a few takeaways investors should glean from this growing debate.

Servers like these are now responsible for most of the market's trading. Image is public domain.

How the market is rigged against us
When Michael Lewis and others speak about the "legalized front-running" of orders on the market, they're not talking about every single order. Front-running every order may be possible, but it wouldn't be lucrative, and the risks taken by traders would be higher than they want to take.

Instead, high-frequency traders are front-running big orders made by mutual funds, hedge funds, ETFs, and any other large investor. These are orders for tens of thousands of shares or more, not your typical order. So, when you buy five shares of Apple, there's probably not a high-frequency trader running in front of that. But when Fidelity decides to buy 50,000 shares of Microsoft, the dynamic changes, and any inefficiency in that order can be exploited.

The other way high-frequency traders have gained an edge on the market is by getting news before everyone else. Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) subsidiary Business Wire announced earlier this month that it would stop selling direct news feeds to high-frequency traders, which currently gives them a small timing advantage on market moving news.

Again, this probably isn't something you or I would notice in our day-to-day investing, but if you're a market-making hedge fund or a large investor, the advance notice granted to high-frequency traders can be a definite disadvantage.

Time is money, and in the world of big trades, the time frame that matters is measured in milliseconds.

Not all trading is rigged -- probably
It's important to understand that not all parts of the market are rigged. In fact, a vast majority of trading is done through standard market making, which high-frequency traders participate in as well. In market making, bids are sent in to the exchange to set a buy or sell price, and when you go in and buy 100 shares, you take up one of those bids. Based on the flow of trade orders, the market will move up and down throughout the day.

This market making activity has long been a highly profitable business on Wall Street, particularly for big trading firms like Goldman Sachs (NYSE: GS  ) , which have the scale to make markets in thousands of securities. If they can effectively manage the risk associated with making markets, they have a high probability of making a profit. That's how Goldman Sachs generated a trading profit every single day of Q1 2010 and every day but one in Q1 2012.

Big banks may not like high-frequency trading as much as you think
Interestingly, when high-frequency traders run in front of big orders, these megabanks can also lose in the trade. They're executing orders for clients, as well as funds they manage, and they make some of the biggest trades on the market. As 60 Minutes profiled, it was Brad Katsuyama at Royal Bank of Canada  (NYSE: RY  ) who uncovered how his company was losing money on trades that should have taken place at market price. But Katsuyama wasn't complaining about being partially filled on an order of 100 shares; he was buying shares by the thousands. When you're talking about rigged markets, scale needs to be brought into the equation.

Because big banks deal in such large numbers, Royal Bank of Canada had to improve its systems to combat high-frequency traders, and it even consulted with others on how to do the same. And it may sound crazy, but Goldman Sachs has even come out in favor of trading reforms. 

Here's the big takeaway for you: Unless you're making an order that's unusually large, the high-frequency traders won't see an advantage by trading in front of it, and the trades retail investors make will continue to proceed as usual. 

The advantage of high-frequency trading
As much as high-frequency trading is getting a bad rap right now, it can be helpful for the market as a whole -- at least when done right. High-frequency traders have helped increase liquidity in the market and shrunk bid-ask spreads to very small levels.

Today, the spread on large stocks is usually a penny, compared to 1/8 ($0.125) or 1/16 ($0.0625) of a dollar when I started investing in the '90s. So, even if your trade is front-run and you pay $0.02 or $0.03 more for half of your shares than what the market originally quoted, the net price is probably lower than it would have been 20 years ago.

Whether or not it's good that computers are making more trades is debatable. There's the potential for algorithms gone awry and byproducts like the Flash Crash. But overall, the argument can be made that the market is more efficient today than it was before computers made most of the trades.

How to beat high-frequency traders
The broader question is how do we beat computers and engineers designing the complex systems behind high-frequency trading. The short answer is: You don't.

In listening to Michael Lewis on 60 Minutes, I could think of only one sure way to beat-high frequency traders: buy and hold stocks for the long-term.

If you're not buying and selling stocks on a frequent basis, there's nothing for high-frequency investors to make money on. They're looking to capitalize on the frequent trading that takes place on the market and any inefficiencies in the exchanges or the way markets are run. If you're simply holding a stock, there's no way for them to profit from you.

You simply don't have the infrastructure to compete with high-frequency traders in a millisecond market, so make your investing time frame longer and take away any advantage they have. They can take the pennies I might pay for getting front run, I'll keep the dollars to be made owning great stocks for a long period of time.

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