It’s called High Frequency Trading (HFT) and a few years ago it was seen as the end of Wall Street as we know it by some. Today the use of computers to make trades is commonplace with roughly 40% of investment-grade corporate bond trading executed through computers up to about 90% of futures contracts computer-based.
Currently, according to The Wall Street Journal, investment banks are beginning to turn to electronic trading for small trades that otherwise might fall through the cracks. It’s also worth noting that small trades (under $1 million) are safer for banks and don’t threaten the profit margins on larger trades – at least until the system is considered reliable.
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What It Is
High Frequency Trading uses computer algorithms to rapidly trade stocks. Highly sophisticated strategies move in and out of trades in fractions of a second. The harm caused to human traders is complicated, but real. For example, a human trader with limit orders floating out in the marketplace can easily get “picked off” by an HFT. It’s called “adverse selection” risk.
HFTs are so fast they can pick off limit orders before human traders can react. Fast, by the way, means less than a second. Much less. The result is filled orders just before a drop in price and shares bought back at much lower prices resulting in huge profits for the HFTs.
Experts note that HFTs trade in only the top 3 dozen or so most liquid stocks. These are stocks with the most bids and offers. Second, according to experts, 50% to 70% of volume comes from HFTs while 90% to 95% of quotes come from them. This is due to what is known as “quote stuffing” or fake quotes. This can fool traders into thinking demand is there when it is not.
Another factor, internalization refers to the practice of paying for order flow from retail brokerage houses like TD Ameritrade and others. This gives the HFT right of first refusal on orders. These trades never make it to the exchange floors for competitive bidding.
Changing The Focus
It didn’t take long for human traders to realize they couldn’t win playing the same game as HFTs – at least not without millions of dollars in investments in computing systems. One solution has to do with lengthening the time horizon for trades.
No longer do many traders see themselves as liquidity providers involved in trades that last seconds for pennies. Now trades last minutes, hours even days. Profits are seen in dollars rather than cents.
Think Small And Succeed
HFTs are not interested in low volume action. There simply isn’t enough money in it. The front-running that scares traders isn’t a problem if you are buying and selling a few shares. If you’re not dealing in tens of thousands of shares, you are probably safe.
To the degree HFTs use their access to news to gain milliseconds of advantage, it sounds scary but again is not likely to be a problem for the low volume trader.
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Long-Term Buy And Hold Works Too
If you’re not buying and selling many stocks on a frequent basis, HFTs have no way to make money on you. If most of your investing is exactly that – investing – you are likely playing on an even field. Stocks you buy and hold are not in play and therefore not a place HFTs can gain a toehold.
Competing with HFTs as an individual is impossible – unless you have enough money to buy the technology to do it. If you do, you probably don’t need to be buying and selling stocks in the first place.