You’ve seen the headlines, listened to the pundits, and bought the exciting novels about all the intrigue, greed, and evil that is High Frequency Trading. Over the last several years, HFT has taken the world of Wall Street by storm, and has caused no shortage of controversy amongst the many market participants. HFT is the process of using computer programs to buy and sell securities with lightning speed, executing thousands of trades in a second, much to the chagrin of us mortals who are limited by our own reflexes. But is High Frequency Trading really the root of all evil? Below are five arguments for why HFT is more than just a vessel for greed, and is in actuality just another tool like any other:
1: Controversy is a business
To get it right out of the way, firms that utilize HFT are not the only groups making money off the phenomenon. At the risk of sounding like a political nutcase, which I’m not I swear, news outlets are not always out for reporting the most valuable information. Most of the revenue for these outlets come from advertisements and royalties, which are all tied to the number of viewers these outlets have. In many cases, in lieu of spending time and energy to report on new concepts all the time, it is easier to sensationalize existing arguments. This controversy is not limited to the news stations however, and many writers are gaining prominence by discussing (read: crucifying) HFT as a practice. Whether or not people should be able to make money with this technology is debatable, but is profiting from the argument any more valid?
2: It’s the next logical evolution in trading
In the wild world of investing, there are several ways to approach research. The two most broad categories of due diligence are known as fundamental analysis, and technical analysis, and are oftentimes confused. Fundamental analysis is the process of looking at what a firm actually does, how the firm performs, the industry performance etc. and making a decision with the expectation that you expect growth. Fundamental analysis is often very time consuming, monotonous, and not entirely glamorous. Fundamental analysis is however, a very strong method of valuing investments, and it is this author’s personal belief that most successful investors perform some degree of fundamental analysis in their selection process.
Technical analysis is the topic up for debate in this article though, and technical analysis is probably what springs to mind when you think of the stock market. In a strict dictionary definition way, technical analysis is the attempt to derive future price movements from past behaviors using any number of tools or patterns. Hollywood does a pretty good job of showing the action packed process in movies, with investors looking at charts and talking about riding trends not unlike surfers riding waves. Technical analysis is often dismissed in academic settings (I.E. undergraduate finance classes) due to the fact that it is relatively new, and unproven. In practice however, under the right circumstances, some success can be had by employing the right technical tools when investing. For instance, while many investors may prefer fundamental analysis to select stocks, they then use technical analysis to decide when to buy or sell.
High Frequency Trading is the next evolution of technical analysis. Most investment brokerages allow individual traders (called retail traders by the big firms) to employ tools to analyze stocks, and HFT is simply the process of doing this analysis really fast on more stocks. This doesn’t mean that HFT is the best method, only that is the where the technology is going. The argument against HFT is that mid-sized firms and retail investors don’t have access to this technology. The flaw in this argument is that technology is heading in this direction regardless, and over time it will be more accessible for others. We haven’t stopped air travel because the commercial railroad travel feels bad, and we won’t be stopping tech advancements for the same reason.
3: You shouldn’t be day trading anyway
I’ll be stepping on a lot of toes for this particular segment. The long and short of it is, if you are a small-time retail investor, you shouldn’t be day trading anyway. I use the term day trading in the sense that you are buying and selling stocks over short time periods to try and beat the market. I can almost guarantee you that you will lose money doing this, even I have personal experience in this. The big firms have access to far more resources than you do, and HFT is just one more tool in the toolbox they have. Instead of sweating the details of whether a stock went up or down.013% today, due to the HFT action, you should be looking at long term investments. Or better yet, put your money in a mutual fund. Sure mutual funds or other retirement vehicles aren’t the glamorous, get rich quick, rock and roll trading lifestyle you expected, but it’s better than the alternative. If you cannot devote all of your time and energy into the market, you will lose your money to someone who is clocking in all the hours you aren’t.
4: What about the benefits?
I day-traded for a while, with mixed results, I never felt cheated by HFT. The truth is HFT provides more “buyers” or “sellers” of security for you to interact with. This extra action means that when you place an order it gets filled almost instantaneously. This may never have been a problem if you only trade stocks that already get a lot of attention (maybe you only trade the blue chip Dow stocks) but what about lesser known stocks? If nothing else this action provides more movement in small to mid-cap for you to profit off of. Those price swings don’t happen out of nowhere, it’s because buying and selling is in a constant struggle to move prices up or down.
5: The Market is already rigged
Perhaps the most frequent argument pundits make is that HFT is that somehow this new development has made the playing field favor the big boys. This unfair technology has made it hard for the little guys to find success. The truth of the matter is that the market has never not been rigged. I don’t mean this in the illuminati conspiracy sense, but more in the whole idea that the markets will never be fair to the less prepared. The stock market is not a blank slate every morning when it opens, it is marinated in all of the news and events going on at all times. Any investor who doesn’t take the time to do any sort of due diligence is going to get slaughtered. What’s more, the big firms are always going to have an advantage, not because of some algorithm that trades faster than you, but because they devote more manpower than you to the market. You may be spending time doing research, and building the best strategy possible regarding one particular stock, but these big firms are doing the same thing, and they may have multiple analysts covering the same security, already giving them the advantage. You are trying to compete with professionals who make it their business to be better than you. Picture stepping on to a football field only to find that the opposing team is from the NFL, it is already rigged and you probably won’t win. Complaining that they are wearing better cleats than you and can move faster because of it isn’t going to change the fact that they spend all of their time mastering their craft.
Conclusion
I don’t expect to win the hearts and minds of the people with a handful of paragraphs, but I do hope the you now realize that it isn’t all so black and white as you may have heard. Yes High Frequency Trading is controversial, but it needs to be discussed in a civil manner and not heralded as the coming of all things evil. You may have this grand idea about how the markets are fair and just, and that even the little guy has a shot to make it big, but the truth is far more complex. The markets are not designed to be fair, or nice in any way. The best way to avoid the “threat” of HFT is to turn it around and try to develop a strategy to profit from it, because while legislation may be underway to regulate it, Pandora’s Box has already been opened and it isn’t going away.