According to bestselling author, Michael Lewis, “the stock market is rigged.” He made this claim during a recent 60 Minutes interview while promoting his latest book, Flash Boys.[1] The reason for his claim (and subject of his new book) is high frequency trading.
The term refers to trades placed at blinding speeds by powerful computers. High frequency traders (HFTs) build their own exclusive fiber optic networks and locate their super computers as close as physically possible to the exchanges where they buy and sell stocks. This enables them to “see” offers to sell and bids to buy stocks sooner than everyone else and react more quickly.
While this is technically legal, Lewis and others contend it is unfair and even a little “shady.” The advantage of speed allows HFTs to extract small profits, sometimes just fractions of a cent per share, in transactions with other unsuspecting investors. Repeated thousands of times each day, these small price differences add up to millions of dollars per year.
As an example, Lewis described a practice known as “front-running”: An HFT computer identifies a large order to buy stock on an exchange; it sprints ahead of that order and buys the same quantity of shares in time to turn around and sell the shares, filling the original buy order, at a slightly higher price. This all occurs within a fraction of a second and without the stock purchaser’s awareness.
Before investors despair at this latest evidence of the lengths to which greedy financial firms go to profit at our expense, they would do well to consider the following:
• Long-term, buy-and-hold investors will rarely, if ever, find themselves in an HFT firm’s cross-hairs. The most common targets are investors who trade individual stocks frequently and in large quantities.
• A buy-and-hold investor’s typical holding period (measured in years) likely makes the potential impact of high frequency trades (measured in milliseconds) irrelevant to achieving their long-term investment goals. Growth in the value of the underlying companies owned in a diversified portfolio should be expected to eclipse the small intraday price fluctuations exploited by HFTs over time.
• Major fund companies, such as Vanguard, are aware of HFTs and confident in their ability to protect shareholder interests.[2]
What is perhaps most striking about Lewis’ revelations is how any ordinary investor using a short-term trading strategy can possibly believe they are capable of outsmarting today’s ultra-competitive market.
________________________________________
[1] http://www.cbsnews.com/news/is-the-us-stock-market-rigged/
[2] Foley, Stephen. “Vanguard chief defends high-frequency trading firms.” Financial Times, April 25, 2014.