High Frequency Trading is Irrelevant

Posted in: Economics, General, Stock Market, Thought of the Week

Last week, Michael Lewis caused a huge uproar during a 60 Minutes broadcast when he called the U.S. equity markets “rigged” and accused High Frequency Trading (HFT) firms of “front-running” trades, which is illegal. First, let’s explain what HFT is and how it works.  High Frequency Trading is a form of algorithmic trading, which uses complex software algorithms and technological tools to trade in and out stocks in a matter of seconds or even fractions of a second. The focus of a HFT strategy is to book small profits daily and these traders rarely hold these positions overnight.

Due to the short-term nature of these strategies, speed is the name of the game. Speed is so critical to these traders that many of them are now spending hundreds of millions of dollars that will allow them to shave off a few milliseconds in execution. The reason these HFT strategies are generally endorsed and even encouraged by stock exchanges is because they provide liquidity in the markets. In almost every circumstance, the more liquid the market, the better and more efficient that market will act.

Michael Lewis is a well-known author who has reported Wall Street’s past by shedding light into many of the illicit practices that existed for decades. His new book, “Flash Boys: A Wall Street Revolt”, continues this theme by accusing HFT firms of “front-running” trades. Front-running refers to someone acting on advanced knowledge of a third party attempting to trade a stock. For instance, a stockbroker received a large order from a client to buy stock XYZ and then purchased XYZ for himself prior to executing his client’s order. The stockbroker made the trade in front of his client, knowing that he would likely profit from the rise in price after the larger client order gets filled. Thus, the stockbroker will then sell his XYZ shares soon after and collect the profits.

To make it simple, there is a lot of controversy surrounding HFT and the possibility that they have an advantage in markets by being able to act on information faster than the “mom and pop” investor. Our Investment Committee is a little skeptical about the motivations of Michael Lewis for a couple of reasons. First, there have not been many instances where he has been complimentary of Wall Street or the broader financial services industry. He appears to be a little biased. Secondly, let’s not forget that his media tour was probably designed to sell more books. However, our Investment Committee does believe that the New York Attorney General and the FBI may uncover some illicit practices that are happening in these HFT firms.

As long-term investors, our Investment Committee is uninterested in HFT because they do not compete in the same arena. Speed traders compete against other speed traders that rarely hold stocks for longer than a few minutes. Long-term investors buy stocks based on the thesis that is expected to play out over a 12-month span. Our Investment Committee is more interested in the quality of earnings and attractive fundamentals that drive revenues and profits. Simply put, the actions of HFT firms have no impact on our long-term investment strategies.

Read this week’s Thought of the Week to learn more about the controversy surrounding High Frequency Trading firms.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.