Although many people are afraid of high-frequency trading, the truth is that it's a boon that only puts one very small group of traders at a disadvantage.
This article published with permission from InvestmentU.com.
High-tech, rapid-fire trading is very much in the news these days.
Attendees at financial seminars and conferences tell me it scares them. Market pundits often say it distorts prices, creates an unfair playing field and punishes Mom-and-Pop investors. “60 Minutes” even jumped into the fray recently with an exposé on this new phenomenon.
The good news, however, is that investor fears about high-frequency trading are unwarranted. It’s a boon — not a boogie man — and puts only one group of traders at a disadvantage. And you shouldn’t be one of those types anyway.
Let me explain…
The influence of high-frequency trading
High-frequency traders rapidly buy and sell large amounts of securities with statistics and algorithms that drive electronic-trading strategies. Using high-speed data systems, linkages with underground networks, and locations strategically positioned close to the servers of electronic exchanges, they compete to buy and sell in increasingly smaller fractions of a second.
Their influence is substantial. High-frequency traders now make up nearly half the daily volume on U.S. stock exchanges.
Critics claim that these traders are high-tech pirates who destabilize the markets and cost most market participants money. They’re wrong on both counts.
High-frequency traders are doing something that you aren’t doing anyway. They’re vacuuming up nickels and dimes. Daniel Weaver, Professor of Finance and Associate Director for Whitcomb Center for Research in Financial Services, points out that the average high-frequency trader’s profit is $0.10 on 100 shares traded. I’ll bet that’s not your own investment objective.
High-frequency traders spot and capitalize on very small discrepancies in bid/ask spreads among various exchanges. In the process, they tighten those spreads and increase market liquidity. These are both good things for us ordinary investors.
How about the complaint that high-frequency traders make stock prices more volatile? There’s no doubt that world equity markets have been particularly nerve-wracking lately. But there’s little evidence that this is due to high-frequency trading. After all, this technique didn’t begin with the market turbulence we’ve had over the last three months. This volatility has been driven by fear of a double-dip recession here at home and the currency crisis in Europe.
And, despite popular opinion, high-frequency trading did not cause the flash crash on May 6 last year. The SEC and CTFC have issued a joint report confirming that the crash was caused by a single large sell order on E-Mini futures contracts, a security that mimics trading in the S&P 500 Index.
Understand too that to the extent that stocks are volatile, it creates actionable possibilities. If a stock soars or plunges in the absence of news, it often creates an attractive opportunity to buy or sell. Prices fluctuate more than values. And to the extent that prices are out of whack, it increases your opportunity for gains.
High-frequency trading’s biggest losers
Who loses out due to this new high-tech trading? Mainly day traders, who are essentially gamblers anyway. I say that because intra-day stock-price fluctuations are almost entirely random. Most day traders would be better off betting on a coin flip. (At least there you have a 50/50 chance of winning.)
Day trading only works when you have a full-blown stock market mania — as we did internet and technology shares a little over a decade ago. When that kind of party ends, as it always does eventually, day traders go back to being bartenders and hairdressers. So to the extent that high-frequency trading deters these individuals, it helps prevent almost certain losses.
The important point is this: As a stock investor or trader, what you should really be concerned about is future earnings and share-price appreciation.
High-frequency trading — which increases liquidity and narrows spreads — does nothing to interfere with either.
Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.