A recent story on 60 Minutes was fascinating and disturbing. The biggest traders on Wall Street are no longer humans representing Brokerage Houses, but uber-speed computers. These electronic traders do not require human intervention to execute their trades, but rely on pre-programmed instructions based on complex algorithms.
The trader – in this case the computer – has no equity expertise and does not know the underlying value of the companies or their stocks. It can make thousands of decisions and execute thousands of trades within micro-seconds. What the computer lacks in fundamental knowledge it more than makes up for in rapidity of trade execution and analysis of trends.
Now some would argue this is old news. The NASDAQ (National Association of Securities Dealers Automated) has been electronic and automated for decades. In contrast, despite its prominence, the New York Stock Exchange was viewed as a quaint equities anachronism using color-coded employees, hand signals, telephones and slips of paper. And although the 60 Minutes piece was broadcast in 2011, some form of High Frequency Trading (HFT) has been around for at least a decade. Of course the sophistication of the technology and the decisions based on mathematical models has improved exponentially.
IS THERE A DANGER?
On the surface this new methodology appears superior. It is fast, cost-effective, not prone to human order-entry error, not subject to emotion, and facilitates trades at the best possible price. It represents another example of the wonders of technology. However, as Lesley Stahl, CBS reporter discovered, high frequency trading has some very vocal critics, as well as some powerful advocates.
The biggest problem in HFT may be the disconnect between investing based on actual (fundamental) value vs. excessive trading based on ever-changing price-points over exceptionally brief periods. Because of the volume of synchronized trades the High Frequency Traders can become market makers and movers creating erratic or distorted volume and price moves.
Some blame the 2010 “Flash Crash” on HFT. From another viewpoint, HFT actually minimizes market volatility and has a leveling effect because the moves in or out of advancing or declining equities is so efficient.
The most compelling danger of HFT may yet be revealed. Like “lemmings going over a cliff” the HFT traders can also make occasional massively bad decisions as well as millions of incrementally superior ones. The other major danger may be a leveling which will ultimately result in stagnation. With multiple HFT operators all looking for an edge, those trading advantages could reduce or disappear. This is because trades rely on buyers and sellers each thinking they’re getting the better deal. If the HFT decisions almost always know what the best deal is, as they increase their market-share the “deals” will become more elusive.
WHY SHOULD YOU CARE?
Some experts feel the market is “rigged,” or at least the odds have shifted dramatically in favor of large traders, especially HFT’s. If you’re an individual investor, even a Day Trader, your fingers can’t move fast enough, nor your pre-programmed buy/sell decisions execute quickly enough, to level the playing field. And, if you’re a Buy-and-Hold investor, you’re just a bystander hoping that fundamental business value will ultimately prevail in the equities marketplace.
So be aware and be careful when investing. Increasingly it’s a “black box” model where decisions are made without transparency by machines that don’t know or care about the companies they buy or the investments they make, only profitability by the micro-second.
I hope this explanation is useful. The implications are clear: Be careful with your investments because the rules of the “game” have changed, and not to your benefit!
