Does high frequency trading ruin returns for ordinary investors?Jun 02, 2017
High frequency trading (HFT) is where technology and algorithms are combined to trade shares at an incredibly fast pace. And when I say ‘fast’, I mean Superman on steroids, fast.
In 1999, when the dot com bubble was in full force and day traders were popping up everywhere, about 1,000 quotes per second (for buying and selling shares) were generated. As technology got more sophisticated, that number exploded to 2,000,000 quotes per second by 2013.
But most of those quotes (in recent times), weren’t initiated by humans – the speed is too fast for us. HFT machines have taken on that role, with 90-95% of all quotes coming from the technology.
The companies using these machines have direct access to stock exchange servers, which gets them an inside look at quotes and trades at ridiculously fast speeds. In 2009, over 2,000 workers were employed to install over 1,000 km of 1.5-inch cable between Chicago and New York, to give direct access to the exchange.
But this technology isn’t just reserved for the States. In our own backyard, Tibra Capital is doing the same. From an office overlooking the beach in Austinmer, Tibra recorded record profits of $79 million in 2016, accounting for several of the founders being members of the BRW Rich List.
The machines aren’t necessarily trading though – just quoting. In fact there are fewer market participants today and less trading.
“All this noise comes from the high frequency guys trying to game each other or fool traders”.
So what are they trying to do?
High frequency traders are constantly sending and cancelling orders. They don’t want to be static, in case the market moves against them. But that technique can also be manipulative, and cause congestion on the trading networks, which gives the high frequency traders an advantage.
It can be seen as front running, where someone, such as a broker or an exchange, knows you are buying shares and then sells them back to you at a higher price. It might only amount to tiny gains per share, but when you’re dealing with high volumes, it adds up pretty quickly.
The book “Flash Boys”, by popular author Michael Lewis (who also wrote Money Ball, The Blind Side, and The Big Short), tells the story of how HFT was used to scam the banking system. And, somewhat scarily, it’s all true.
This Amazon reviewer provided a simple explanation of the phenomenon:
“My favourite analogy is my local farmers' market. When I show up to buy strawberries, some farmers/dealers have way more information on the supply and demand, and have inventory to reflect their view. They will rightfully make a profit when I buy the basket of strawberries from any of them. What I don't want to see is some jerk get in the way and buy up all the strawberries just before I hand my money to the seller, then turn around and sell the strawberries to me as if he had been the seller all along. The price quoted at my farmer's stand should be the price I can buy strawberries at, not a new price some jerk just jacked up to after seeing my intention to transact.”
Now let me tell you about the 10th of May 2010. Known as the Flash Crash, the Dow Jones lost around 9% in a matter of minutes, wiping trillions off the books in the US market. For a moment, it looked like the end was nigh, fuelled in part, by high frequency trading.
Take a listen to this guy who was calling it live. It starts to get pretty funny from around the 2:30 minute mark.
But just as quickly as the crash happened, the markets started to recover – not fully, but the final 3.2% decline was a whole lot better than the 9.2% one.
But it begs the question, what are the risks to long term investors – like you? Are you being ripped off, just by being “slow”?
Let’s take a step back.
A common strategy investors utilise is called a “buy and hold” strategy. This is where you buy an asset and hold onto it for a period of time, until you feel that it has reached its maximum level of return, or you need the proceeds for a specific purpose.
Buy and hold investors look to invest in companies based on their future earnings power. The gains can take years to materialise and requires patience. But it’s how Warren Buffet, who in 2015 was the 3rd richest person in the word, has earned his billions.
So what does a trade every nanosecond have to do with a buy and hold strategy?
It’s still an ongoing debate within Wiseman Financial Services, but at this stage, it would appear to be nothing.
What does it matter what happens on a nanosecond-to-nanosecond basis? Or for that matter, a minute-to-minute basis? Or for that matter, a day-to-day basis? How is it that these fraction of a second trades, impact an investor's ability to meet their financial goals?
Acting on impulse is usually a recipe for poor outcomes when it comes to investing. Scroll back up to that chart again and remember that someone sold stocks just before 3.00pm on 10 May 2010.
At the close of trade on 10 May 2017, 7 years after the flash crash, the Dow Jones was 20,943.11. That’s almost double the close (10,520.32, with a low of 9,869.62) on the day of the flash crash 7 years earlier.
The bottom line is, if you’re investing into the future earnings of a business and that investment will provide you with capital growth or dividends in the future, then what goes on in the short term, is irrelevant.