High-Frequency Trading: What You Need To Know

Being the "little guy" in the markets is never easy, it seems.

The recent airing of a "60 Minutes" special concerning high-frequency trading (HFT) and Michael Lewis' new book, "Flash Boys: A Wall Street Revolt," went into detail on how retail investors are being duped by this new wave of algorithmic gurus and computer experts.

Lewis' book has sparked controversy across the investing community, with the "Liar's Poker" author claiming the stock market is "rigged." Some high-frequency firms argue the heat is unwarranted, saying they provide liquidity and keep fees down. Just how bad investors are being affected and just how much money is being made from HFT practices have been debated since the program aired.

Ignoring the noise and concentrating on the actual problems present in the market's current structure, increased complexity and poor regulation are two real drivers that have had a tangible malevolent impact. While attempts have been made in the past to level the trading playing field, the end result has often been segmentation, reduction in liquidity -- and fatter pockets for those who created the "solution."

That is, until now. A large component of the "60 Minutes" special outlined the debut of a new type of exchange, known as IEX, which aims to put investors first.

Although the exchange is still in its infancy, it has attracted some notable investors, including David Einhorn of Greenlight Capital. The billionaire hedge fund manager has high hopes for the new trading venue, expecting it to "succeed in a very big way." Also on IEX's board is the legendary Jim Clark, co-founder of Silicon Graphics and Netscape.

YouTube/The Economist

Although the exchange is still in its infancy, it has attracted some notable investors, including David Einhorn. The billionaire hedge fund manager has high hopes for the new trading venue.

While they may be motivated by potential profits, improved execution is always a positive factor for large investors such as Einhorn. Those positive effects can trickle down to the small investor, as many institutions (such as retirement funds) dole out money to Wall Street managers as part of their diversification efforts.

IEX has created a venue for buy and sell orders to meet with the retail investor in mind. The exchange displays its trading rules for all to see, which is not a common practice in today's environment of proprietary information and algorithms. One of the most standout principles is the enforcement of a 350-microsecond delay between trade requests and executions. This pause hopes to keep some long-standing HFT strategies from being successful.

IEX's structure is also a large selling point: It has no broker-owners. An example of a broker-owner operating an exchange would be Goldman Sachs creating a dark pool (such as its Sigma X platform) to attract volume away from the NYSE and into its internal pool. IEX says that because it has no broker-owners, there will be no conflicts of interest or prioritizing of order flow, and most, if not all, existing brokers will be able to trade on IEX. (Goldman has already voiced support for the exchange.)

Two of the most predatory practices are known as sub-pennying and flash orders (which inspired the title of Lewis' book). "Sub-pennying" allows certain firms and market participants the ability to trade at fractions of prices and step in front of displayed orders. Flash orders come about when orders are displayed on the open market, only to be pulled suddenly, enticing other investors to push or pull the stock in a certain direction based on what they perceived to be a counter-party.

Keep in mind that the above two strategies (along with other predatory practices) are what occur when operations are running smoothly. If a glitch occurs, much larger and detrimental effects can take place (remember the "flash crash" of 2010 or the algorithmic mishap that nearly buried Knight Capital Group in 2012?).

So what are the implications for the average middle-class investor?

If you manage your own money and execute your own orders (as a non-professional), trading on IEX with reduced participation from HFTs could mean slightly better fills and prices without being "gamed" or side-stepped. That said, the negative influence of HFT is actually minuscule, as HFT can provide some benefits to do-it-yourselfers, including better execution speed and lower fees.

But what if you are among the majority of individual investors and are thinking "I'm not a trader - my job/bank/money manager handles all of that for me." The implications could actually be even greater due to the way these institutions participate in the open markets. Your money is often lumped in with thousands of other accounts and traded based on risk, mutual fund, or 401(k) allocations.

The resulting pool of money that includes individual investors' hard-earned dollars must now be worked into the market millions of dollars at a time, providing signals to certain HFT firms that hurt the prices you receive while putting money in their pockets. IEX aims to stop this.

Risks to consider: IEX is competing with upward of 50 other execution destinations, so volume might be light in the coming months. As more participants sign up to trade on IEX, liquidity and speed should rise dramatically. Also, as history has shown, some firms may find workarounds to IEX's rules, reintroducing the threat of predatory tactics.

Action to Take -- The support of positive market structure reform is the first step towards better pricing for smaller investors. As an individual investor, you can lobby your broker or money management firm to bring their business to IEX. In the meantime, focusing on longer-term strategies and abstaining from taking excess or unnecessary trades will keep your investment dollars in your pockets, not HFT firms'.

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By: Eric Winter