Michael Lewis, author of Liar's Poker and The Big Short, explains in a 60 Minutes interview how the stock market is rigged against anyone without a fiber optic line to the stock exchanges. And chances are, you don't have one of those. Just how is the market rigged, and what can you do about it?
If you enter in a trade through your broker, it has to travel across various wires before your buy or sell is executed. While your trade signal bumbles along to the exchanges, those with faster connections can spot it at the exchange the order hits first and then place their own order before yours at the following exchanges, driving the price up or down and making fractions of a cent on the ensuing transactions of less speedy traders. Lewis describes it as "legalized front-running."
And while each instance of "legalized front-running" may not be very profitable, those tiny margins add up at least enough to cover the costs. The 60 Minutes episode discusses a company called Spread Networks, which spent $300 million to lay a fiber optic cable from futures markets in Chicago to the exchanges in New Jersey, allowing trades to be made 3 milliseconds faster than the second-fastest route. And now, high-frequency trading firms are spending $10 million each to lease this line.
According to Lewis, one $9 billion hedge fund estimated that this practice cost it an estimated $300 million per year because its orders were too slow. And while it probably doesn't cost you as much, you still could be paying pennies more per trade. But there is a solution.
When former Royal Bank of Canada trader Brad Katsuyama recognized this issue, the way he beat it was to slow down his orders so that they hit all the exchanges at once, eliminating any chance that a high-frequency trader would cut in front of his trade. Katsuyama has since created a new platform that has a built-in safeguard against high-frequency traders. It's called IEX, or the investor's exchange. Many brokers can execute trades through this platform, which claims greater transparency.
Adding to IEX's legitimacy, Goldman Sachs (NYSE:GS) has thrown its weight behind the exchange, claiming that Goldman Sachs has one of the most active traders using the system -- this despite the fact that Goldman owns competitor BATS, which recently surpassed NASDAQ to become the second-largest stock exchange in the U.S. behind the New York Stock Exchange (though all hover claim about 20% of equity market share). Still, the five-month-old IEX has a long way to go before it becomes a major player, as trades on the new platform represent a tiny fraction of total trades: Its average daily volume in February was about 15 million versus 6.9 billion for all U.S. markets.
If your broker has yet to connect to this even-playing-field exchange, there is another way to beat the machines: act like one. While your human brain may tempt you to trade in and out of stocks based on greed or fear, attempt to be as logical as possible and remember the words of Warren Buffett: "Our favorite holding period is forever." The more you trade, the more fees you'll rack up, and the more high-frequency trading can increase your expenses.
In short, if you remember that an investment should be long-term, then you won't lose sleep over the fact that the market is rigged against those of us without direct fiber-optic lines.
Dan Newman has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. 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.