Before the publication of Flash Boys: A Wall Street Revolt, (Michael Lewis), high frequency trading (HFT) was not much understood by either the average investor or even, it is fair to say, the professional. Now everyone is scrambling to get up to speed (pun intended). HFT got its start after the government moved to encourage increased competition among stock exchanges. This led to the creation of a whole new smorgasbord of competing exchanges, at last count thirteen public ones and over forty private “dark pools.”
High speed traders are in the arbitrage business. They buy a stock in one market and sell the same one in another when they see price disparities. They figured out that some exchanges are quicker to get to than others so when a trade hits a fast exchange they take that knowledge and race ahead or ‘front run’ on the slower exchange, profiting by just a teeny amount but when multiplied by an enormous number of trades, it becomes real bucks. By 2009 high frequency traders were doing 60% of all trading on U.S. stock exchanges.
Proponents of HFT argue that they add liquidity to the market, they narrow the spread between bid and ask, and they lower commissions. The dark side of HFT however is it increases the cost of institutional buys and since institutions manage mutual funds and other pools for individuals, the public pays a price.
We are not fans of HFT and are in favor of levelling the playing field on Wall Street but keep in mind this is not in the same league as sub-prime mortgages and credit derivatives which nearly brought the economy to its knees. As the charts below show the gravy days of high speed trading, at least in stocks, are probably past. The percentage of total trading by HFT is down and profits are not what they used to be. We are long term investors looking for sound companies trading at inexpensive prices. When HFT takes a nick out of a stock it costs us real money but at the same time we don’t think Wall Street is rigged against the serious long term investor. HFT, now on the front page, will get reined in.
