High-Frequency Trading Mainly Hurts The Traders And Short-Term Investors

Apr 2 2014, 3:57pm CDT | by

Not to deflate the highly admirable “Flash” book of Michael Lewis, but front-running on Wall Street, which is what high-frequency trading is all about and what it really intends to be, is old news. Front-running is one of the oldest tricks in the market, closely following the more notorious and widespread illicit insider trading

What’s new is that speedy price scalping is now accomplished much faster, within nanoseconds, thanks to the latest technology and help from smart algorithm manipulations – and its continued free reign in the otherwise closely regulated industry. Where are all the market sleuths and regulators that have been so blind to what Michael Lewis has uncovered?

The flash traders aren’t in hiding. They are in fact proud of what they have been able to achieve in the stock market that has bewildered a lot of people. But who really gets hurt from such so-called high-frequency trading?

Not so much the small individual investor, to be sure. But the largest victims are the professional traders and short-term investors among the institutional investors who are major heavyweights in stock investing, and whose strategies matter most to the market. It is the insight and advanced peek into these big investors’ massive scale of buying and selling that high-frequency traders lust after as it’s pure gold to their bottom lines.

Both traders and short-term investors who invariably whirl in and out of financial securities are victimized in that they end up paying a higher price over a short window or limited time for what they buy. But for long term investors, the impact is much less and not as dramatic on their total returns since they don’t depend on quick returns.

Long-term investing has proved to be the most rewarding investment strategy, come high- or low-frequency trading. What counts the most to the long-term investors is the quality of earnings and attractive fundamentals that drive revenues and profits. In most cases, their stock portfolios spiral higher in the span of five years to 10 years, or more.  

Unless the individual investors are short-term oriented or engage in market timing, the impact of the higher-frequency trades on their transactions are pretty much insignificant. And the small investors’ market behavior matters much less to the fast traders as their transactions are miniscule compared with those of the large managers of mutual funds, private and government pension funds and major activist investors.

To repeat, front-running is old hat, but what’s new is the sudden decision by government agencies such as the FBI, Securities and Exchange Commission, and the New York Attorney General to suddenly launch separate investigations to ferret out possible criminal behavior among the fast traders.

One aspect of the probe is to detefmine whether these front runners are in fact guilty of insider trading. No doubt it’s admirable that they have started to probe into fast trading and its impact and legitimacy, but one wonders where they have been all these many decades when front-running has been among the most lucrative trickeries in the market.

The paramount question is what is enabling and abetting high-frequency trading? A major source of data that the flash traders pounce on can be traced to the major stock exchanges which in fact share such proprietary material to high-frequency trading companies that aims to stay ahead of everyone else in trading securities. If that source of premium information that aren’t otherwise available to everyone else is plugged or banned, a big part of the problem would be resolved.

It’s that simple. Simply stop the exchanges from sharing and deploying such material information in violation of the privacy of investors. Clearly, if there are areas of the market that need to be urgently regulated, high-frequency trading is one of them. 

So is the stock market rigged?

That’s a far-fetched assumption and difficult to prove — and a gross exaggeration. But what’s clearly visible is that most investors continue to make money from stock investing despite the market’s volatility. Over the years, investors have made tremendous retuns from the market powered by the persistent climb by the Dow Jones industrial average, S&P 500-stock index, and NASDAQ.

True, there have been all kinds of market irregularities, illegal trading and distortions, and crashes along the way. Insider trading, for one, is singularly a dark side of the market that continues to bedevil investors and the market. 

But then again, if you track the market’s various major stock price charts over these many years, they have all been on the rise and climbing to new all-time highs – rigged or not.

 
 

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