Man vs. Machine: Can the retail investor compete with high frequency traders?

Man vs. Machine: Can the retail investor compete with high frequency traders?
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By Tony Matos

Computerized trading has become a double edged sword in the financial market. Computers have facilitated the ease with which transactions take place, yet with the introduction of High Frequency Trading (HFT) in 1999, many believe that the technology has advanced to the point of becoming a torment. High Frequency Trading is capable of completing trading transactions in nanoseconds and even in microseconds, which has impacted the business dramatically.

There is an ongoing debate over the advantages and disadvantages of these highly sophisticated computer programs. While both sides present valid arguments, it is important to look at how HFT affects different groups of market participants. Long term investors are said to be the least impacted by the HFTs, although they do face some risk when placing their buy and sell orders. However, because they focus on the longer term, they are not affected by short term gyrations created by High Frequency Trading. These investors typically look at fundamentals, and long term charts (weekly and even monthly), and invest in the growth of a company and the economy. They tend to place their orders at pre-determined prices, and stand by that order, regardless of the short term movements.

As the investment time horizon begins to shorten, the effect of HFTs becomes more relevant. The short-term investor/ trader is definitely more susceptible to the oscillations created by High Frequency Trading. These types of investors are looking at daily and perhaps even intraday charts in order to make decisions, and typically don’t put much weight on the fundamentals. They rely on price movement and news headlines to move in and out of positions to realize a maximum profit in the shortest period of time. This puts them in the High Frequency Traders’ playground, and many don’t realize it until it is too late. While they practice sound investing and trading principles, by setting stop-losses and entering orders through accredited brokerages, they don’t realize that the HFTs have an unfair speed and information advantage. By spending millions of dollars on lightning quick trading systems, and paying millions more to be co-located at a stock exchange site, the HFT firms are stacking the odds in their favor.

Many systems are built to trade when key words appear in headlines and have built in algorithms that will automatically start buying or selling based on those keywords. The HFT firms receive the headlines within fractions of seconds after the release, and purchase the stock ahead of anyone else. Furthermore, there are other systems that are created to trade off the HFTs when the new headlines are released. This is what is believed to cause the huge spikes seen during intraday trading, and are referred to as “mini flash crashes.” The average short term investor/trader doesn’t stand a chance. By the time they are buying, the move has hit its peak, and the sell side machines are being triggered to unload their profits. The result is, that for many, they are buying in at the highs and are then forced to sell at the lows. The machines move onto the next stock, the liquidity dries up, and the stock gets stuck in a dead zone of sideways trading.

The third group of market participants affected by High Frequency Trading is the institutional and professional traders/ traditional market makers. Although this group often makes a living off the markets, most are still impacted by HFTs and algorithmic trading. These individual market makers are vulnerable to the HFTs as it is part of their duty to take the opposite side of trades. In Canada, market makers, or Registered Traders (RT) are responsible for trading all odd lots on their stocks of responsibility (SORs). Furthermore, it is their obligation to take the opposite side of a trade when there is no one willing to put up an order. As a result, when HFTs begin their assault on a stock, the RTs are affected, as many algorithms break up a large part of their orders into smaller odd lots which the market makers are then forced to take. Within seconds they are now long or short thousands of shares, and the stock has moved in the opposite direction, leaving the RT with a massive loss on his hands. This has led to the slow demise of the market making business in Canada, with many firms closing up shop due to losses and high costs (Desjardins, Canaccord and Dundee were just a few of the recent victims).

On the institutional side, the challenge lies in trying to execute large orders without triggering the algorithms that will quickly drive up the stock price. HFTs are always looking for abnormal price and volume movements, and use their speed to get ahead of the larger orders with the goal of riding the momentum the large orders create. This leaves the institutional trader at a great disadvantage, as he is almost always getting his order topped by a computer algorithm, or sees the offer being pulled and moved up in the blink of an eye. The result is that orders may have to be broken up in order to get filled, which is a practice that is frowned upon by regulators in Canada.

Having said all of this, there are ways that the regular investor can protect himself/herself against the big machines. Using a longer term horizon may be one of the better options, however even the shorter term investors/traders can use techniques to protect themselves. Experts suggest using limit orders vs. market orders to receive a better fill price, and to exercise patience in getting filled. Also, being more cognizant of one’s stop-losses, and not placing them at obvious levels where HFTs will take them out. Finally, being aware of the High Frequency Trader’s presence and exercising caution and discipline when trading, will greatly reduce the chance of losing hard earned capital.

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