Has High Frequency Trading Ruined The Stock Market For The Rest Of Us?

If you are an investor, high-frequency trading (HFT) is a part of your life even if you don't know it. You have likely purchased shares offered by a computer or sold shares purchased and then instantly sold by another computer. HFT is controversial. Traders disagree with each other and studies contradict other studies, but regardless of the opinions, what is most important is how HFT affects your money.

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What Is HFT?
HFT is a broader term for various trading strategies that involve buying and selling financial products at extremely high speeds. Computers can identify market patterns and buy or sell these products in a matter of milliseconds based on algorithms or "algos."

One strategy is to serve as a market maker where the HFT firm provides products on both the buy and sell sides. By purchasing at the bid price and selling at the ask price, high-frequency traders can make profits of a penny or less per share. This translates to big profits when multiplied over millions of shares.

Does It Hurt the Market?
One would think that because most trading leaves a computerized paper trail, it would be easy to look at the practices of high-frequency traders to provide a clear-cut answer to this question but that is not true. Because of the volume of data and the firms' desire to keep their trading activities secret, piecing together a normal trading day is quite difficult for regulators. Those who debate this issue often look at the "flash crash."

On May 6, 2010, the Dow Jones Industrial Average mysteriously plummeted 10% in minutes, and just as inexplicably, rebounded. Some large blue chip stocks briefly traded at one penny. On Oct. 1, 2010, the Securities and Exchange Commission (SEC) issued a report blaming one very large trade in the S&P e-mini future contracts, which set off a cascading effect among high-frequency traders. As one algo sold rapidly, it triggered another. As more sell stops hit, not only were high-frequency traders driving the market lower, everybody, all the way down to the smallest retail trader, was selling. The "flash crash" was a financial snowball effect.

This incident caused the SEC to adopt changes that included placing circuit breakers on products when they fall past a certain level in a short period. In the wake of the flash crash, many asked whether imposing tighter regulation on high-frequency traders made sense, especially since smaller, less visible flash crashes happen throughout the market with regularity.

Does It Hurt the Retail Investor?
What is important to most of the investing public is how HFT affects the retail investor. This is the person whose retirement savings are in the market, or the person who invests in the market in order to gain better returns than the near non-existent interest that comes from a savings account. A recent study shed some light on this question.

According to The New York Times, a top government economist found that HFT firms are taking significant profits from what they call traditional investors, or those who are not using computer algorithms.

Studying the S&P 500 e-mini contracts, researchers found that high-frequency traders made an average profit of $1.92 for every contract traded with large institutional investors and an average of $3.49 when they traded with retail investors. This allowed the most aggressive high-speed trader to make an average daily profit of $45,267 according to the 2010 data. The paper concluded that these profits were at the expense of other traders and this may cause traders to leave the futures market.

Although the authors did not study the equity markets where high-frequency traders account for a large amount of stock trading volume - possibly 70% or more, according to some reports - they say it is likely that they would reach the same conclusions.

The Bottom Line
The overall sentiment that the small investor cannot win in this market is beginning to proliferate. Some blame the massive amount of uninvested cash as proof that many have given up and lost confidence in the markets. This has become such a problem that even high-frequency traders are looking to other world markets to find the liquidity they need to conduct operations. Regulators around the world are looking at ways to restore consumer confidence in the stock market. Some have proposed a per share trading tax while others, such as Canada, have increased the fees charged to HFT firms.

Because of the relative newness of HFT, the process of regulation has come slowly, but one thing that does appear to be true is that HFT is not helping the small trader.

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