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Why We All Should Care About High Frequency Trading

High Frequency Trading

I remember the date vividly. The news was abuzz about the upcoming IPO that was coming out…that IPO was on Facebook. Everyone was talking about it and hopes were high by many people that they’d get their hands on some shares. I mean, who wouldn’t want to get some shares? The company has supposedly over 900 million users and is bound to be a successful public company. The hoped-for hoopla was short lived due to a little followed, but growing issue known as high frequency trading that caused chaos on the opening day of the Facebook IPO. Some would argue that the issue of high frequency trading has been a problem since the market plunge back in October 1987 and was seen in causing the Flash Crash in 2010 amongst other instances. So, bear with me as I let my inner trading geek out as we look at the issue of high frequency trading.

What Exactly is High Frequency Trading?

High frequency trading employs highly quantitative algorithms, run by computers, that look to buy and sell securities in a very quick fashion. For a typical high frequency trading firm, the normal holding time for a security is a matter of seconds to several hours at the most. High frequency traders invest in stocks, options, ETF’s, currencies, and futures; any equity that can be traded electronically is fair game to a firm involved in high frequency trading. It is highly unlikely that you’ll find an individual investor involved in such trading as high frequency trading is commonly left to small, but growing firms that are usually trading with their own money.

What Are the Effects of High Frequency Trading?

“So what?” you might be thinking, “how does this affect me as Mr./Mrs. Investor?” The answer is that it can affect you quite a bit. One of the main effects of high frequency trading is that through the aforementioned algorithms they’re able to see how other, more everyday investors are trading milliseconds before they make their own decision. Does this sound right? No, it does not. Better yet, many exchanges also offer minuscule small kickbacks to those traders that arrive first with their orders. So, over time the high frequency trading firm is able to make money through these kickbacks. For anyone who’s seen Office Space, it’s similar to the scam they ran. Yes, these two effects do make me pause and wonder if we should put more regulations on high frequency traders. Some studies have argued that we benefit from high frequency trading as it lowers the price for retail investors and brings liquidity to the market. I am not entirely sold on their argument yet though.

What Are Other Countries Doing About it?

I’ve read numerous articles over the last few weeks about how other countries are dealing with high frequency trading. Each article recounted how many of these countries had modeled their markets after ours and wanted to be like the markets in the U.S. What they all went on to say was they’re seeing what’s becoming of the American market and don’t want to run into similar issues. Countries across Europe, to Australia and Canada are either looking into, or are putting measures in place to regulate high frequency trading. Generally I am not one to think that government regulation is always the best solution. But, what does it say when many of our friends are initiating regulations because they do not want to become like us? What does it say when these firms are forming groups that are lobbying lawmakers to not regulate them? It causes me to sit back and ponder whether or not we would benefit from regulations on high frequency trading.

Should We Just Give Up Investing?

Gone are the days where people line up on the market deciding on what price a stock should be bought and sold at. Does this mean we should all give up on stock investing and bury our heads? My irrational side says yes, to heck with the market and just put my money in CD’s or under my mattress. But, part of being frugal requires us to be informed and make wise decisions with our money. In the end, I am still involved in the market and will be investing in stocks and other investments for years to come. Yes, there are things about high frequency trading that concern me and hopefully some of it does to you as well. The solution though is not to give up on stock investing all together as I see it as a key to saving for my retirement. Part of the solution has to be increased education about how to invest and how your investments are doing. Maybe it also means that you contact your Senator/Congressperson to tell them you think we should have regulations on high frequency trading. At the very least, it should mean that you stay more informed about your investments and what’s going on in the market.

 

Is this the first time you’ve heard about high frequency trading? Does it cause you to want to be more informed in regards to what’s going on in the market?

Photo courtesy of: brcwcs

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I'm the founder of Frugal Rules, a Dad, husband and veteran of the financial services industry. I'm passionate about helping people learn from my mistakes so that they can enjoy the freedom that comes from living frugally. I'm also a freelance writer, and would love to help out if you have the need. If you're wanting to grow your blog, check out my blog coaching services to see how I can help you take your site to the next level.

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31 Comments

  • Pauline says:

    I knew about automated trades and that many companies chose micro trades as a way to limit risk. They would buy at 1 and sell at 1.0001 which is probably a safe trade because whether the price is going up or down there is often a bounce around round numbers. I tried to trade currencies for a while and used a series of small trades too, with strict stop loss and take profit, but as a person it is very stressful, I would rather hold on to stocks for a longer term.
    Pauline recently posted…How I sold my flat… again!My Profile

    • John says:

      I know that can be the case with trading currencies. I’ve wanted to give it a try for a while, but just don’t think I have the stomach to stick with it. I know stocks much better, so I stick with what I know.

  • Michelle says:

    I actually did a long research paper on HFT for my Finance MBA. It’s very interesting to look at, and it seems like there are numerous positives and negatives. Of course it’s good for those who have the time and money to trade a ton though.
    Michelle recently posted…Spending, Life, Income and Food Updates…My Profile

    • John says:

      I’d be interested in reading it! I think HFT is very interesting, and there are many drawbacks…but some positives as well. I still don’t know where I’d fall on it though. I think some regulation would be good, but just not certain the government can really do it justice.

  • I would actually be interested in reading Michelle’s paper on this! Not that your post didn’t give a good overview, I’m just curious about the more detailed analysis of it. I personally don’t think it’s a huge issue because the market will always correct itself. If trades drive the stock up or down drastically, the market will eventually push the stock to a more reasonable price.
    DC @ Young Adult Money recently posted…How Zillow Fueled My Real Estate ObsessionMy Profile

    • John says:

      As would I DC. I stayed away from the in depth analysis in fear of making people go cross-eyed at the details.

      The thing is though, is that it’s a fairly big issue. The Flash Crash, to the FB debacle, to Knight Capital (and these are just the ones that we know about) have all been tracked to back to it and there’s very little regulation. It also feeds the fear of those that are irrationally fearful of the market.

  • Call me a cynic, but I just think there is too much money involved for governments to really crack down on this type of activity.

    I have learned to live with it and just try to catch the movements when they are going in the same direction as me, then get out before it turns. It’s more like gambling than investing, but there can be good gains to be made if you’re careful.
    Glen @ Monster Piggy Bank recently posted…Facebook Giveaway Winner – Best Sites and Lessons LearntMy Profile

    • John says:

      Great point Glen. Some have argued that and it and the argument can hold some water. The important thing, as you say, is to know when tyo get out.

  • It seems like they are gaming the system to me. Just because something is legal doesn’t necessarily make it right. It seems to me that they are just finding ways to continusously skim money off the top while employing strategies that the average investor isn’t able to use. I don’t like it.
    Holly@ClubThrifty recently posted…Saving Money, It All Adds Up…and a Giveaway!!!My Profile

    • John says:

      Many definitely feel that way Holly. The fact that some of the firms are hiring lobbyists also makes me uneasy. Unfortunately many don’t know that it’s going on and as a result are blind to it.

    • Holly – what do you think about investors that buy specialized investment reports where someone has already done research and makes specific stock recommendations? Depending on the analyst publishing these reports, they can be VERY pricey and the average investor isn’t able to access them. Does that make them immoral to use? Just food for thought…

      From my perspective, this isn’t all that different. HFTs have the resources to run these trades, and it’s provable that there is way more liquidity in the market than there was 20 years ago before trade automation. I’ve heard increased liquidity described as one reason that retail trading (like eTrade at $7/trade) is so much more affordable than it used to be.
      Mrs. Pop @ Planting Our Pennies recently posted…How Do You Go From Minimum Wage to $80K In A Year? Part 1My Profile

      • John says:

        You’re right, Mrs. Pop, that many have argued that HFT has brought down the cost for the retail investor so they can have better, lower priced access. I don’t know that I completely agree with that, but the argument does have merit. On a side note, most of the larger retail brokerages only have to pay $2-$3 per trade, so they’re making quite a nice profit on the trades when you look at how many most of them execute a day.

        In regards to comparing HFT to paid analyst reports, that really is comparing apples to oranges. Often times those reports are pricey like you say, but if you have the money you can get access to many of them. (That by the way is a separate argument of having money vs. not having money and if its fair to give that info only to those with money) The issue with HFT is that most if not all of the traders are actually (so the argument goes) seeing our trades before they place their own. Add to that the fact that they’re now hiring lobbyists to protect against regulation and you can see that many of the fears are not unfounded and do hold water.

        I haven’t completely decided where I fall on this issue yet, but I do think there is some cause for concern and that if nothing is done the retail investor will again lose out to the big institutions.

  • I think the same thing someitmes. Eh, forget it, I’m just putting my money under a mattress! Haha!
    TB at BlueCollarWorkman recently posted…Should You Go Against Fire Code When a Client Asks?My Profile

  • I’ve always known that most transactions were done by computer. But that flash crash last year really opened my eyes as to how terrible things could become even if one little glitch or mistake happens. While there is nothing any of us can really do to turn back the hand of technology, we do have to be aware of our surroundings and possibly even be willing to accept that they days of an 8% average annualized return may be a stretch.
    My Money Design recently posted…My Money Design – October 2012 UpdateMy Profile

    • John says:

      I think that was the first thing that opened up some peoples eyes, although some say it’s what helped cause the crash in 1987. There have been too many instances of it causing major problems for it to not be looked at more in depth. I agree about the 8% return, it does require much more work these days.

  • Cat says:

    Yup, it’s news to me. Doesn’t sounds like a great idea – cause a lot of flux in a short period of time.
    Cat recently posted…How to waste money – put your Ipod shuffle through the wash..My Profile

  • I think I’m going with TB and will try the mattress. No, I don’t really understand it but get the general concept. I think people will bend rules as far as they can without breaking them. It’s alot like that in health care. If I pluck out 5 ingrown eyelashes, which takes about 3 seconds, I can legally charge a fee for each one, which would be hundreds of dollars. I don’t do that, but lots of people do and they are within the law to do so. The legal billing code does not match the level of service, so people take advantage. That’s what drives up the cost for everyone.
    Kim@Eyesonthedollar recently posted…Can You Avoid Spending Money on School Fundraisers?My Profile

    • John says:

      I can understand that feeling Kim. I’ve spoken to many people who feel the same way. The key is to not just give up like so many do. I agree that many will just go as far as they can legally without actually breaking the law. That’s real interesing about your line of work. I am sure it’s that way across many sectors, which is a shame because as you said the consumer ends up paying more as a result.

  • Liquid says:

    Must be at least $10 million worth of equipment in that picture :D It’s too bad about the kickback and the unfair lack of regulation in the system. Automation of electronic trading isn’t bad by itself. It can be used for good, like making cheaper the cost of doing business because you don’t have to hire people to execute actions. But just like any good technology, some people with a lot of money found a way to use it in selfish ways and high frequency trading is the result. I’m not sure what the solution should be.
    Liquid recently posted…Expensive Impulse ShoppingMy Profile

  • John says:

    I know. :) I agree that the automation is not bad in and of itself. It’s those that are running it and using it to their advantage of making big profits off of it and then lobbying to protect themselves. Many argue that it does lower costs for all of us, which is great, but is now being manipulated by some. I am not certain what the solution is, but believe one needs to be found.

  • Veronica @ Pelican on Money says:

    I watched a documentary on HFT a while back. It explained how some of the technology being used is actually far ahead of anything regulators have the possibility of regulating. And I guess those math wizard genius guys are making 300k / year for starters and well over a million for those who know what they’re doing, so I can imagine they’re rounding up their own lobbyist to send to the capitol. Quite honestly I’m afraid of what’s going to happen in this country if we don’t regulate that sort of thing. We already failed with broadband.
    Veronica @ Pelican on Money recently posted…How to Make Your Paychecks LastMy Profile

    • John says:

      I think I may have seen the same documentary. There is great money to be had in it, but you have to know your stuff to do it. The thing that show me where their intentions lie is forming lobbying groups. I think there needs to be some sort of regualtion, but I really question how effective the government would be at enforcing it.

  • There’s always going to be little things like this in high money making industries. But the stock market has averaged 10% since it’s inception. Invest in low cost index funds and you’ll come out ahead of 95%(I’m just making this number up, but I know it’s super high) of day traders.
    Harry @ PF Pro recently posted…Save Money on Your Flu Shot This WinterMy Profile

    • John says:

      I agree Harry. I think you really need to know what you’re doing as a Day Trader to really beat the market. It’s even more difficult to do it without having a massive margin loan. It can be done, but is difficult.

  • Savvy Scot says:

    I’ll be the first to admit that I don’t know very much about HFT. It is not the first example of where technology supersedes regulator’s ability to regulate! This happens in the Energy industry all the time, as well as Consumer electronics. Big companies such as Apple and Amazon are educating the regulators to their advantage… in this case, why would a company want to educate the regulator when they can make such vast sums of money?! Crazy to think that this goes on and is not just a movie storyline!
    Savvy Scot recently posted…10 Tax Tips for Contractors & FreelancersMy Profile

    • John says:

      Great point Sir! Things like this are not just exclusive to the trading/investment industry. In fact, you could probably find it going on in most industries. I know it is crazy, but is going on every day with more firms starting up regularly.

  • I’m not into high frequency trading. For the long-term approach, it’s not the best solution. It’s very costly and requires a disciplinary strategy involving put/call options, limit order, etc to minimze losses and regulate your gains. You have to really know what you are doing and you must know that the money used for HFT is at a high risk of loss. I say, if you are going to do it, use funds that are not for retirement.
    Ornella @ Moneylicious recently posted…You Have a Network, You Just Don’t Know ItMy Profile

    • John says:

      You’re right, you do have to know what you’re doing and it does take a lot of money to engage in HFT.

      With HFT though, it’s not individuals doing it but institutions that are doing massive amounts of trades in huge chunks. This is a bit different from someone engaging in Day Trading, which I would agree should not be done in one’s retirement accounts. Actually, there are regulations in place to not allow true Day Trading in retirement accounts so investors don’t put too much risk into their retirement investing.

  • Derek @ MoneyAhoy.com says:

    This does not really hurt you if you are a long term investor, but if you’re trading it can kill you.

    HFT and algos can read and parse through news in milliseconds. This can move the markets around and stop you out faster than you can blink.

    If you’re owning stocks for years and years, two or three cents higher entry charge is like a drop in the ocean.

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