High Frequency Trading

Posted on Thursday, June 19th, 2014

Since the beginning of business transactions, people have looked for “an edge,” or a way to make a buck by being smarter and faster. That’s the basis of competition, and over time, consumers tend to benefit.

In capital markets, it’s no different. In 1906, it was reported that one big-time investor was able to communicate sell-short orders to his broker in New York before the news of the San Francisco earthquake impacted stock prices. In the 1980s, affordable computers gave traders “an edge” that put other traders and some investors at a distinct disadvantage.

In 2014, stocks can now be transacted more than a million times faster than the average human can process a thought. Math geniuses have created algorithms and computer programs to identify microscopic patterns and trends in the market and exploit these diminutive movements within milliseconds. This may seem inconsequential at first, but if a stock is purchased at one price and then sold $0.0001 higher, and that same transaction is repeated over 10,000 times per second, the proceeds are not insignificant. This is referred to as high frequency trading (HFT).

So, what does this mean for me, the average investor?

In short… not much. Whether it’s 1906, the 1980s, or now, there have always been middlemen extracting a profit for providing additional liquidity to the markets. Like all business transactions, these traders also assume significant risk. However, this risk tends to be a “win-win” for both HFT firms and investors, who benefit from lower trading costs due to additional liquidity in the market.

Advancements in technology and market practices have always, and will always, outpace the rate at which Wall Street is able to regulate. That is the price to be paid for innovation and progress. Initially, there may have been a price to pay for HFT – we will never know.  But now, HFT firms mostly trade with other HFT firms, and as long as the average investor is not trying to win the pricing arbitrage game that HFT firms play, they can benefit through lower trading costs. Lower transaction costs are a result of HFT due to the high volume of trades performed every minute, thus tightening the spread between the bid-ask price and lowering commissions on trades.

In time, regulators will try to determine if markets would benefit from reducing or eliminating HFT.  In Canada, it has been argued that eliminating HFT increases the bid-ask spreads by 9%. That is a lose-lose scenario that we hope we will not see in the U.S.

 “So, now that you have told me that HFT does not really affect me as an investor, how does WBFG’s investment philosophy deter risks associated with HFT?”

HFT is not a new phenomenon; instead, it has been evolving over the years. Though some market participants do use speed and information to try to make a profit, Dimensional Fund Advisors (DFA) uses advanced trading strategies that have also been evolving over the years. DFA’s strategies are designed to minimize turnover and allows them to patiently wait to transact. For example, DFA’s portfolio managers do not require traders to transact in every eligible stock or bond, but rather traders have eligible lists of names that are suitable for investment. The whole trading process is designed to minimize cost and protect clients from any unnecessary costs. At WBFG, we focus on asset allocation, tax efficiency and sound investment behavior. These three strategies tend to have a higher probability of achieving successful investment outcomes, thus making matters, such as HFT, much less impactful or irrelevant.

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