There’s been a lot of chatter about high-frequency-trading (HFT) — here’s a quick take on the topic for people scratching their heads.
What is HFT anyway?
Imagine a stock that’s moving up in price due to strong buying demand. A HFT program recognizes the trend and executes thousands of sequential buy and sell orders within seconds. Each buy and sale is done at progressively higher prices due to the upward price momentum.
The program basically buys low and sells high many, many times in a blink of an eye. Even by netting only fractions of a penny per trade, HFT can add up to huge profits due to the sheer volume of transactions. Those profits come from other market participants who end up buying higher and selling lower than they should have.
In another example, a HFT program could submit a high volume of buy and sell orders, but cancel them before execution. This creates an illusion of outstanding bid and ask prices for other market participants. By the time others submit their orders to sell or buy, the illusory bid or ask is gone, and the order executes at an unexpected price (with the HFT trader pocketing the difference).
Uneven playing field
HFT firms use the latest computer technology, special arrangements with stock exchanges/brokerage firms, and even laser-beams — like something out of a science fiction movie to increase speed and profits (seriously, you can read about the lasers here).
It’s easy to see why HFT firms are being accused of using unfair advantages. Yet, it’s not absolutely fair to say HFT is absolutely bad. It can have useful applications. For example, HFT could help market makers provide liquidity, and it could also help with price discovery — those could be seen as general benefits for all investors.
What you can do
While some say that HFT really targets institutional investors, individuals can certainly get caught in the trading-crossfire as well (even if only indirectly through mutual funds). Ironically, the best thing individuals may be able to do about HFT is nothing at all. In a game where the odds are heavily stacked against you, the best strategy may simply be not to play.
The more investors trade, the more they are playing into the HFT game — and that’s a losing proposition! You might have two monitors with blinking lights and some online brokerage accounts, but that won’t level the playing field against HFT firms that trade at the speed of light with billions on the line.
Fortunately, there are other games in town. Whether you focus on little-followed sectors and industries where you have expert insight or just buy and hold low-cost index funds — there are ways to put the odds in your favor. It may not be as exciting or as instantly gratifying as day-trading, but consistently tilting the odds in your favor is a solid way to win at the investing game over time.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog represents advice.