Since the publication of Michael Lewis’s new book, Flash Boys, a startling amount of attention has been given to the practice of high-frequency trading. HFT is a nuanced and highly complex part of the investing world, but despite this, the book seems to have touched a nerve with people wondering what really goes on when stocks are traded.
HFT refers to electronic trading strategies that use speed and technology to exploit tiny price differences in various markets in an attempt to gain an advantage over the market. High-frequency trades are characterized by extremely short holding periods and a high turnover of securities, and account for a significant amount of trading volume in today’s markets.
The practice has sparked a heated debate between more traditional investors who seek long-term value, and HFT proponents who say their high-speed trades create market efficiencies. At Leith Wheeler we invest clients’ capital with a long-term view, and probably wouldn’t call ourselves traders at all, but rather long-term owners of select public businesses. Nonetheless, clients have been asking us about this practice so we thought we’d provide a few insights.
How do investors like us deal with high-frequency traders in the marketplace? Doug Clark, head of ITG Canada’s Liquidity Group, produces research on a variety of aspects of capital markets, and his firm helps Leith Wheeler execute our investment plan in an HFT-impacted stock market. We asked for his insights.
The first thing to note about HFTs, Clark says, is that their impact on the average investor is not all negative. In fact, overall, it might be positive. The practice has added efficiency to stock markets by linking liquidity among similar securities, asset classes and across borders. These efficiencies have brought down the cost of trading for retail investors, particularly in exchange-traded funds and other highly liquid securities. For example, 10 years ago there might have been as much as a four- or five-cent difference in the price of Barrick Gold shares between the Toronto and the New York stock exchanges. High-frequency traders have closed this difference to two-tenths of a penny today through competition among themselves to capitalize on irrational price differences. The smaller spread in Barrick Gold share prices equates to trading cost savings for other investors.
However, as Lewis’s book argues, it isn’t all positive for investors. Some factions among high-frequency traders will try to interpret when other market participants are trying to buy or sell large quantities of a stock and then use their speed advantage to execute the same buy or sell before the other investor. This practice results in the large stock trades paying more to buy or sell as the high-frequency traders’ ultra fast small orders push the price of the stock against them. Predatory tactics like this have existed ever since markets began. Having a faster processing speed is just the latest way to exploit an information advantage. Other market participants have needed to learn better ways to disguise their buy or sell intent from high-frequency traders. Some traders have also built faster, more direct fibre cable infrastructure or located closer to the electronic stock exchanges in order to shave fractions of seconds off their processing speed and maintain their speed advantage over the rest of the market.
Not entirely good or bad but with the heightened attention HFTs are garnering lately, there will likely be legal or regulatory changes to the way they do business.
This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.