Don’t Play in The Street
High Frequency Trading
Since the 2014 release of “Flash Boys” by Michael Lewis, high frequency trading has been on the front page of nearly every investing publication. There have been many individuals calling for the SEC to intervene and increase regulation, but few have hinted at the positives that have resulted due to this practice. Is high frequency trading evil? It depends whom you ask.
Simply put, high frequency traders try to profit from the price movements caused by large institutional trades. When a mutual fund sells a large number of shares, the price dips. High frequency traders buy on the dip, hoping to be able to sell the shares a few seconds/minutes later at the previous price. Additionally, when a mutual fund buys a large number of shares, the high frequency traders short the position, hoping to close their position at a profit. In practice, high frequency traders are not looking at just one stock in isolation; they are looking at all the prices coming in, including stocks, bonds, commodities, futures and options. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High frequency traders can also earn tiny profits, millions of time over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of traders. They are focused on short-term blips not long lasting trends.
Critics of high frequency trading have concluded that the practice hurts the average investor by imposing a “speed tax.” This tax is taken from the pockets of people who buy and sell stocks and puts it into the pockets of the high frequency trading firms. If you trade only a few stocks per year, your tax is very small. Trade millions of shares per day, and your tax is quite large.
The software programs that high frequency traders use have the potential to destabilize the market. Wharton Finance Professor Franklin Allen believes that this kind of fast trading (high frequency trading) can give rise to frenzies. If many traders use automated strategies that key off the same factors, the programs may all jump on/off the bandwagon at the same time causing potential destabilization.
Proponents point to lower trading costs and increased liquidity in the market place as examples of why high frequency trading should not be dismissed entirely. Gus Sauter, Chief Investment Officer of the Vanguard Group, says that small investors have benefitted from a significant reduction in trading costs due to narrowing spreads as a result of high frequency trading. Generally, wide spreads are seen as a kind of inefficiency, with buyers and sellers having difficultly coming to an agreement on price. Narrow spreads mean the market is more efficient. In addition, Sauter believes that high frequency trading has helped reduce the “market-impact” cost by making it easier to break big trades into many little ones, while still conducting them very quickly. Trading costs from spreads and market impact have been cut in half over the past decade, Sauter says, from 0.5% of the trade amount for big company stocks to 0.25%. Small stocks’ trading costs have dropped from 1% to 0.5%. “High-frequency trading teases out hidden liquidity. There may be something out there that’s difficult to find. The high-frequency people do find it one way or another, and they turn around and offer it back into the marketplace.” Economist Fischer Black once explained that we need noise in the markets. Noise creates opportunities for arbitrage. It creates vibrancy and discord, and makes the markets liquid. High frequency trading creates a great deal of noise.
We have been aware of the potential issues caused by high frequency trading, at least in a general way, for years. We are less affected than most by high frequency trading practices because of our low turnover style of investing and our general pattern of using “limit orders” when we buy and sell. One tactical response we have made in recent years is that once we place a limit order, we are less likely to raise our bid or lower our offer than we might have been in the past. This means we have missed “fills” on some trades but have achieved a better, albeit later, execution on others. While we do not believe that high frequency trading has had a material adverse effect on our investment results, we continue to both follow news developments and refine our trading tactics.
All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.