"The stock market is rigged [by] a combination of the stock exchanges, big Wall Street banks, and high-frequency traders."
-- Michael Lewis
Best-selling author Michael Lewis is no stranger to big controversial ideas. This past Sunday, Lewis went on 60 Minutes to discuss his new book "Flash Boys," which delves into the story of how high-frequency traders, or HFTs, are making predatory trades and rigging the market.
Here's how it works: Using supercomputers, fancy algorithms, and fiber-optic cables that shave milliseconds off of trading times, these traders can spot purchase trends in the market. After a trend is spotted, traders can buy in front of you and then sell assets back at a higher price. Lewis referred to this as a type of "legal" front-running -- or making trades with advanced knowledge of pending orders.
HFTs earn a percentage of a penny on each trade. Not particularly effective once, but do it millions of times a day, and those pennies add up to billions per year. While there are investigations into the legality of this type of trading, it's unlikely high-frequency trading will go away anytime soon. For this reason, investors need to learn how to adapt to a world polluted with predatory trading.
1. Become an individual investor
An "individual" investor controls the buying and selling of their own assets. Why is this important? When Warren Buffett starts to make an aggressive move on a stock, to a computer, it's about as subtle as a cannon being shot off. The same goes for hedge funds, mutual funds, or any big organization filling a very large order.
As an individual investor, however, the buying and selling of a few hundred shares is hardly a blip on the radar. Therefore, you're much less likely to run into serious problems with high-frequency traders.
2. Be a long-term investor
I'm not a technology or high-frequency trading expert, so let's assume I'm totally full of it, and these supercomputers notice every trade you make. At most, assuming the stock price isn't already rising, you'll paid a few extra cents per share. Which, on a purchase of 100 shares of a $25 stock, could cost you two or three dollars.
For some perspective, you're already paying a $6 to $10 in trading fees (double it because you pay to sell), so we're talking about starting in a $23 hole.
This could really add up fast for investors who make high numbers of trades. If, however, you bought the stock because you think the underlying business will grow substantially over time, then the extra starting loss, while unfair, won't hurt you nearly as much in the long run.
3. Use limit orders
When executing a trade, most of us use what are called "market orders." We essentially say, "I want to buy [this many] shares at whatever price the market is currently offering." Limit orders, on the other hand, allow you to set a specific price at which to buy. If the price exceeds that "limit" then the purchase will end. This way, if high-frequency traders, or general market euphoria, start bidding up the price, you won't be susceptible.
The bottom line
The deck has always been stacked against the individual investor. Because there's always going to be someone who can get and act on information faster. However, if you want to beat fast, you have to be slow.
It may seem counterintuitive, but you might be better off if you slow down your approach and focus on the fundamentals of the businesses you're buying. Think about holding for the long term instead of making quick profits. The individual investor can still be successful in today's "rigged" market.