The ABCs of High Frequency Trading

High frequency trading, otherwise known as HFT, has become a huge buzzword since Michael Lewis’ 60 Minutes interview on March 30.

In the interview, Lewis explains that High Frequency Traders are a new contingency of lighting fast stock traders.

Using massively intelligent computer system, they are able to identify large stock trades that are milliseconds away from being fully transacted. Think of a stock trades as an online order. It might take a second or so for an order to make it from one computer to a stock exchange and back again, in order to be fully executed or fulfilled. These HFT groups have computers and fiber optic data lines that are so fast, they are able to see stock trades that are in the process of being ordered. This allows them to swoop in, and buy large volumes of stock right before the original buyer is able to complete their transaction. Once this takes place, they are able to turn around and sell the same stock back to the buyer who originally wanted the shares, only for a slightly higher price – making them an unnecessary middleman.

Lewis is saying that this practice makes Wall Street “rigged” and that ordinary investors are being charged unfairly. You can watch clips from Lewis’ interview here.

Media outlets have been clamoring about this idea, and it has spread like wildfire. HFT is scaring people because they don’t understand it, and all they hear is that they are somehow getting scammed. Creating this sense of fear and interest, though, is actually Lewis’ goal since he is trying to sell a book on this subject.

Let’s take a step back and actually look at how HFT works, and how it affects you.

The Good

High frequency traders help to provide liquidity (the ability to buy and sell securities whenever we want) in the market and also allow companies like Charles Schwab to charge only $8.95 per trade as opposed to the $50 it cost many years ago.

With the technologies that have been developed, we are also now able to trade stocks whenever we want during the day and we can see how much money we are making from the palm of our hand.

The Bad

You or I might purchase 200 shares of Coca-Cola right now at around $40 a share. If you add $0.01 to each trade, it totals to an additional $2. That won’t break the bank.

When big institutions like Vanguard and Fidelity purchase stocks, though, they typically purchase in bulk, maybe millions of shares at a time. Suddenly we’re talking about tens of thousands of dollars!

The mutual funds or ETFs aren’t going to just eat this cost, so it’s passed along to the ordinary investors like you.

To Recap

HFT actually has some positive attributes, mainly because it provides liquidity for all market participants. The groups behind HFT are demonstrating capitalism, technological innovation and entrepreneurial spirit, all of which I applaud. However, I don’t have to like that they’re skimming off the top of my investments.

What you can do

The fact of the matter is that HFT does not keep ordinary investors from making money. They are now, however, another cost of investing. The best thing you can do is keep all your other investment costs as low as possible. Read the best way to do this in my past blog post about the Seven Layer Dip of Fees.



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