Avoiding High-Speed Traders

The stock market is rigged to help the rich and powerful who have access to high frequency trading algorithms– and regulators are doing little to help individual investors. The only way to avoid this hazard is not to trade a lot.

The traditional model of the stock market is one where rational investors aim for long-term profit by carefully assessing equities based on publicly available information. That model is no longer valid. In fact, the majority of trades are made in the matter of nanoseconds by supercomputers with no human input at all.

High-frequency trading (HFT) is out of control. The TABB Group estimates that HFT accounts for 73% of all trades on American stock exchanges.

HFT gives an unfair advantage to those with the means to use it, creates volatility, distorts stock prices and loosens the relationship between how well a company is managed and the price of its stock.

Another problem is that trading computers do things that can land Homo sapiens in prison. Somehow, it’s legal for computers to make decisions based on information that isn’t available to the public, even though the Securities and Exchange Commission is clamping down on insider trading by people. Is a computer that mines data to find and take advantage of pricing inefficiencies any different from a hedge fund manager buying stocks based on a leaked memo that only he has access to?

In its defense, the SEC recently began investigating a broad range of HFT-related issues. These include the structure of proprietary market data feeds, the adequacy of testing of automated trading algorithms and the development of order types geared toward automated trading.

The regulators also recently fined the New York Stock Exchange $5 million in a settlement of trading-related allegations. The exchange allegedly violated market regulations by providing customers of its proprietary data feed with access to market information faster than that it provided this to the public.

HFT increases volatility as well. For instance, let’s look at the prodigious rise in the price of Netflix (NFLX) stock on Jan. 24. While the stocks of many major companies were down significantly that day – Apple (AAPL) fell 10%, for example – Netflix jumped 38%.

True, Netflix announced an unexpected profit during the fourth quarter so its stock price should have increased, but a 38% rise is a bit extreme. That is a huge jump even for a full year, and yet it happened in a matter of minutes.

No one knows for sure why the price jumped this much and this fast, but it was likely the result of a short squeeze. Here, shareholders bet that a stock will fall. The process is known as shorting: They borrow it and sell it, expecting to buy the shares back later after they tumble. In a squeeze, the price surges and the short-sellers must purchase shares to exit their short positions. Regardless, HFT made the squeeze a crushing one. There is no way that human traders can work up such a huge rally that quickly.

HFT can also be used with other price-altering schemes, such as momentum ignition, where someone attempts to trigger other participants to trade quickly and cause a rapid price move.

For regular flesh-and-blood investors, the prevalence of computerized trading is more reason to trust a professional financial advisor and hold stocks for the long term. Independent day traders, who buy and sell to take advantage of intraday price swings, are no match for algorithms that trade at the speed of light.

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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.  
 
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