Michael Lewis’ most recent book, “Flash Boys,” has caused quite a stir among Americans. It has sparked a huge debate about the strength, reliability, and trustworthiness of the stock market. Lewis’ book suggests that High-Frequency Traders can take advantage of microseconds during buy/sell transactions so they can jump ahead of everyday retail investors. This scenario has the potential to result in retail investors paying more for stocks. Is this really happening? More importantly, how does it impact the Main Street retail investor?
I hate to break this to you, but the answer to that first question is yes. High-Frequency Trading (HFT) firms are very technologically advanced. Their trading systems have the fastest processing times in the industry, especially when compared to those of the retail investor. These high-quality systems are linked directly into the stock exchanges to allow the HFT firms to see all open orders on the exchange. They work by searching for people who want to buy 100 shares of stocks using a market order. For example, if a stock is trading at $50 dollars per share, the high-frequency traders may buy 100 shares of the stock for $50 with plans to sell all 100 shares to the retail investor for $50.01. The HFT firm will keep the one penny as profit in what is called a risk-free trade. This may be only a penny difference, but as my grandmother once told me, “If you watch the pennies, dollars begin to grow.” The HFT industry has grown into a multi-billion dollar business by trading risk-free and fleecing the investor on Main Street.
Although HFT is a multi-billion dollar industry, some say it’s a bad thing because it also caused the flash crash on May 6, 2010, the biggest one-day point decline in Dow Jones Industrial Average history. HFT put out millions of buy orders, which was deceiving because it made the market look strong until suddenly those buy orders went away and reappeared with no buyers of stocks. When this happened, the market dropped 1,000 points in a matter of seconds. HFT puts many buy orders out there too fast, and this made it look like there were no buyers of stocks in the market, which, I don’t have to tell you, is a dangerous scenario.
Now that the secret about HFT is out, how does HFT impact the everyday investor? You pay more! The everyday investor ends up paying more for stocks than he or she did before HFT came along. This same scenario is also happening to large mutual funds. Many retail investors are bypassing selecting stocks, going straight for mutual funds. However, HFT is impacting large mutual funds in the same way. The end result is the same: Whether the everyday investor is buying stocks or mutual funds, HFT is driving up the cost. Over time, this cost can damage long-term returns and investment performance.
A solution to the HFT Fleecing could be to use an exchange that does not participate in HFT, such as IEX, an alternative trading system that does not succumb to the lure of High Frequency Trading.
If you’re concerned with how HFT is affecting you and your savings, check with your account custodian/trading platform to see if they offer trading through IEX’s alternative trading system.