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About Me

Darren Winters is a self made investment multi-millionaire and successful entrepreneur. Amongst
his many businesses he owns the number 1 investment training company in the UK and Europe.
This company provides training courses in stock market, forex and property investing and since
the year 2000 has successfully trained over 250,000 people.

Wednesday, 30 April 2014

High Speed Trading and the Small Investor

The advent of electronic trading in the 1990's brought a faster dimension to the trading experience when it began to replace the system whereby traders on the floor of exchanges would buy and sell by shouting orders at one another. As improvements in technology accelerated the speed of communications and made transaction processing ever more efficient, so more traders opted to go this route, and today it is the rule rather than the exception.

By the late 90's electronic trading had also become available to the little guy - the retail investor. In America 20% of the population took advantage, compared to 5% ten years earlier. The man on the street could participate easily, and also relatively cheaply.

But retail investors have a minimal impact on market movements, because the vast volume of traffic goes through institutional investors, banks, hedge funds, private trading firms and exchanges, all trading with one another. And they've always had the advantage over the little guy, just by getting their orders filled faster, and by being closer to the action. The use of electronic trading sped up the process from day one for everybody, so where does high speed trading fit into the mix today, and why has it become suddenly so controversial?

High speed (also known as high frequency) trading utilises fast processors and fibre-optic communications lines to place multiple orders that are transacted incredibly quickly (in milliseconds) to get in and out of the market at a rapid rate. They take advantage of even small price differentials to make small profits, but by placing millions of transactions these profits add up to significant amounts. The principle behind it all is one of gaining advantage by being able to exploit these differentials ahead of everyone else. The programs driving the trades consist of complex algorithms that look for specific market conditions, which once found trigger a buy or sell order, or sometimes a cancellation if this suits the purpose. Current estimates put the volume of all current exchange trading by high speed traders at around 50%. And it's so profitable that a firm called Hibernia Networks is allegedly spending $300 million to run a fibre-optic cable across the Atlantic to connect Wall Street and the City, just that few milliseconds faster.

High speed traders say they bring benefit to the markets by acting as market makers who provide enhanced liquidity, and by narrowing the bid to offer spreads, thereby making market participation cheaper. They also claim that it makes the market more efficient. Critics respond by citing the opportunities high speed trading creates for manipulating the market. An example of this often quoted is the practice of 'front running', where a trader anticipates your order to buy a block of shares, and before you can place your order he has bought in ahead of you, driving the price up. He then  sells them back to you for a profit. Essentially he's using his advantage in speed and volumes of transactions to drive a stock down, then buy it back for later sale at a higher price.

This kind of behaviour generates an ethical argument. By getting in first the high speed trader could be said to be acting on inside information, which is not only unethical but also illegal. In fact, in April the FBI announced that it was opening an investigation to establish whether high speed trading firms are practising insider trading. The results should be interesting, to say the least.

Another alleged practice is the detection of stop losses in the market. The high speed trader once again takes advantage by selling to trigger the stops, then profits when the price swings up again. So if you're a small investor with your stop in the same place as thousands of other players, some of whom are trading large volumes, your relatively trivial trade could be taken out at the same time.

The complex and sometimes less than well tested algorithms have caused market volatility way in excess of the norm. The so called 'Flash Crash' of 2010, when the Dow Jones Industrial Average dropped 700 points in minutes, was triggered by an algorithm executing a sell trade based on volume and not price or time. Other high speed trading firms leapt in to buy, but then tried to reduce their positions minutes later by selling. The original algorithm then increased the volume of sell orders, and the market went into a tailspin. At some point the original instigator must have pulled the trade, and the market recovered by day's end. This kind of computer generated volatility has caused controversy, and dents investor confidence.

So how does all of this affect the small investor? You could argue that high speed trading damages our pension funds by anticipating and profiting from the trades these funds make on our behalf. Or that our insurance premiums are affected when Insurance companies suffer in the same way. Perhaps the unexpected volatility caused by the odd flash crash adds an increased level of risk to your trade, should you be unlucky enough to be in the market on the day. Or maybe you'll suffer when your stop loss triggers as a result of a market algorithm.

But the truth is, high speed traders aren't interested in the little guy. They spend most of their time competing against each other, and if they were to target retail trades the volumes involved would most likely be too insignificant to be of interest. This doesn't mean that the retail investor is immune to the high speed trading phenomenon. An algorithm is logical and takes action unemotionally, which theoretically confers advantage over the human being, who trades subject to fear and greed. I personally don't think this should drive you out of the market, and especially not if you're holding stock for the longer term.

If you want to know more about the high speed trading market and the issues around it, you might like to read Michael Lewis's book - 'Flash Boys', available on Amazon. Only recently released, it seems to have generated plenty of controversy over the practice.

Darren Winters


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