High Speed Trading: More Risk Than Reward?

A look through this month’s headlines shows a heated controversy over a complicated area of the market that many average investors probably don’t spend much time thinking about: high speed trading. From Dean Baker at the NY Times and Clem Chambers at Forbes to the Associated Press, it seems everyone has a heated (and different) opinion over whether the phenomenon of high speed trading is a help or a hindrance to individual investors and to the market.

"For several years, the Wall Street wizards who built a faster, more fragmented stock market justified their creation by pointing to the benefits it yielded for investors in the form of lower trading costs,” wrote Nathaniel Popper in a NY Times pieces this month.

“But as the speed and complexity of the markets have continued to change at a rapid pace - with trade times now measured in millionths of a second - a growing number of studies and market participants suggest that those benefits to investors have stalled or even started to reverse.”

Chambers and others, however, disagree.

“The investor is not affected [by high frequency trading],” wrote Chambers on Aug. 13. “High-frequency trading … is mainly discomfiting to traders and speculators, not to those we think of as investors—who concern themselves with a company's long-term performance,” wrote Holman W. Jenkins, Jr., a WSJ columnist, on Aug. 10.

And yet, a recent report prepared by New York trading and research firm Pragma Securities LLC indicates that the frequently expressed argument that high frequency trading technology can’t negatively impact the average, long-term investor may be incorrect.

“Investors trying to trade cost-effectively often find themselves standing in line behind the fleet-footed traders and are forced to wait to execute their trades, which in turn can cause poorer results,” said the report, according to the WSJ.

A look at the data suggests that the true winners in the high-speed trading game are not investors but the high-speed trading firms, which utilize software, vigilant employees, and fast data connections to detect and act upon tiny differences between stocks on different exchanges.

“After all,” writes economist and author Dean Baker, “many of these programs are designed to pick up large trades and effectively jump in ahead of the trader. For example, if a major investor or mutual fund was in the process of selling a large amount of G.E. stock, a high-speed program may detect the movement. The high-speed trader could then short G.E. stock and buy it back immediately after the big sale and get a guaranteed profit. This has the same effect on the stock market as insider trading. Insider trading is bad for markets because it means that normal investors will get a smaller share of the gains. The same holds true with the high-speed trading platforms that now dominate the market.”

Reuters’ financial blogger Felix Salmon agrees:

“The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second. Sometimes, the casualties are merely companies like Knight, and few people have much sympathy for them. But inevitably, at some point in the future, significant losses will end up being borne by investors with no direct connection to the HFT [high-frequency trading] world, which is so complex that its potential systemic repercussions are literally unknowable.”

Salmon’s correct that the casualties caused by Knight Capital’s $440 million meltdown were restricted to the company, but that’s only because the company’s partners bailed it out. What happens when another company’s algorithms go haywire and there’s no one to pick up the pieces? Like with the over-valued shares of Facebook that resulted from its flawed initial public offering, average investors will be stuck with the fallout. Hopefully, after Knight’s meltdown this month, regulators will begin to turn an increasingly scrutinizing eye to high frequency trading firms and the practices of high speed trading.