The debate over high frequency trading (HFT) has reached the boiling point this week. With the Congress and the SEC now looking into the practice the endgame is in place. In a certain sense the debate is now out of the hands of the blogosphere and is in the hands of politicians, regulators and industry participants.
The debate over high frequency trading has been interesting (and voluminous). One school of though believes the opaque nature of these trading programs might very well be the cause of a financial market meltdown. See Paul Wilmott, Zero Hedge. There is no shortage of proposals to reduce HFT including taxing equity transactions or simply abolishing continuous trading.
In some middle ground you can find a camp that believes HFT may be unfair and may constitute a tax on liquidity. But in the end it does provide some much needed liquidity to the markets especially in light of the liquidity issues seen in the teeth of the economic crisis. (Although the nature of that liquidity is in some doubt.) See Jon Stokes, Felix Salmon.
On the other hand some view HFT as the logical outcome from the introduction of massive amounts of computing power onto the markets. As the old systems of market making and specialists fade from the scene other parties filled this gap. This view is consistent with a future decrease in profitability as competitors enter the market. See Erik Falkenstein, Tyler Cowen. Indeed we may see this already taking place with the dearth in returns at Renaissance Capital.
The questions surrounding HFT are interesting from an economic and public policy perspective. The question for individual investors is whether it matters?
The fact of the matter is there have always been haves and have-nots in the market. Technology has been changing from time immemorial and there have been investors seeking to profit from it, including Nathan Mayer Rothschild. (One counter example may have been the so-called ‘SOES bandits’ who were able to use to their advantage of systems designed for small trades.) From The Economist:
Asymmetric information is nothing new. Even its critics concede that most HFT is perfectly legal. But some of the advantages that accrue to high-frequency traders look unfair.
Small investors have always been facing an uneven playing field. Trading systems have been designed by (and for) the big money players. With cheaper technology and a fragmented trading world HFT has “exploded.” From the Lex column in the Financial Times:
Markets have always been skewed against retail money, whether information sloshes around an open-outcry pit or a high-tech algorithm.
Don’t expect that to change any time soon. Adam Warner at the Daily Options Report is skeptical that the authorities will find any wrong doing, even if there is some. In any event, he writes:
There’s not an even playing field out there. Learn to live within it or don’t trade/invest, unfortunately it’s that simple.
If that is case what is the small investor to do? Pretty much what you are doing now. Nothing is going to change all that quickly. If your trading methodology and portfolio management techniques are humming along, there is nothing we have learned about HFT in the last month that should change anything. If there are new rules promulgated and systems changed it might be worth reviewing what you are doing, but the outcome is likely the same.
Great traders in a very real sense “own” their trading system from methodology to order entry. They are not dependent on any one else and are responsible for their profits and losses. Every trader has stories of bad fills, but they don’t dwell on them. If you don’t own your trading system, that means some one (or thing) does.
Novice traders often blame unseen forces for their trading mistakes. The HFT meme plays right into these fears. When trades go wrong traders should examine their system for improvements as opposed to casting blame elsewhere. This really comes back to the question of knowing what you are doing and what you own. No one, especially some computer, is going to do any favors for you. Blaming a network of autonomous trading computers for your woes serves no purpose.
It may turn out to be the case that in HFT we saw the rules were either skirted or broken altogether. Only time (and lengthy and expensive investigations) will tell. The fact of the matter is that it will likely have little or no bearing on you and your trading.
Is the system unfair to the little guy? Yes, but you are going to have to move past this realization to become a better, more mature trader.