A Simple Way to Sidestep High-Frequency Traders

I was in Las Vegas last week for the Value Investing Congress. The irony of that statement is not lost on me. Then again, the stock market can often seem like a casino — or worse, a rigged casino. Especially with all this talk about high-frequency trading, or HFT.

There is a lot of buzz about HFT. You almost can’t open a financial publication without finding something about it. But how relevant is it to you? Should you care?

These are the questions I sit down to answer now.

Caution: Value investors at work.

Michael Lewis, famed author of such financial classics as Liar’s Poker and The Big Short, kicked off the frenzy with a new book called Flash Boys. Because Lewis is a famous, best-selling author, this book got a lot of buildup and a big push. And it is all about HFT.

These traders use computers program to swap stocks at speeds 100 times faster than the blink of an eye. The firms using this technology have spent billions to gain an edge of just milliseconds over everybody else. Here is an exchange that sums up the gist, from the now famous 60 Minutes interview with Lewis:

Michael Lewis: The insiders are able to move faster than you. They’re able to see your order and play it against other orders in ways that you don’t understand. They’re able to front-run your order.

Steve Kroft: What do you mean front-run?

Lewis: It means they’re able to identify your desire to buy shares in Microsoft and buy ’em in front of you and sell ’em back to you at a higher price. It all happens in infinitesimally small periods of time. The speed advantage that the faster traders have is milliseconds; some of it is fractions of milliseconds. But it’s enough for them to identify what you’re gonna do and do it before you do it at your expense.

It sounds bad. Lewis is making the case that the stock market is rigged against you. These thieves are just picking you clean for riskless profits.

They are. But here’s the thing. Markets, in this sense, have always been rigged. Here is Cliff Asness of AQR Capital Management in an Op-Ed in The Wall Street Journal:

“Much of what HFTs do is ‘make markets’ — that is, be willing to buy or sell stock anytime for the cost of a fraction of the bid-offer spread. They make money selling at the offer and buying at the bid more often than they have to do it the other way around. That is, they do it the same way that market makers have done it since they were making markets in Pompeii before Mount Vesuvius halted trading one day.”

Well put. And true. For what it’s worth, Asness, who manages some billions of dollars, has no problem with HFTs. He thinks they lower trading costs compared with the old days.

Lewis early on paints a somewhat nostalgic picture of the day when floor traders — actual human beings — executed orders. “The world clings to its old mental picture of the stock market because it’s comforting; because it’s so hard to draw a picture of what has replaced it.”

The problem with this is that the good old days were hardly good. Those human beings were expensive. In simple trading cost terms, investors paid way more back then than they do today. The inescapable fact is that trading costs are way down for everybody.

However, I’m not defending HFT. Even if you don’t know much about markets, this is something that just doesn’t pass the smell test. The idea of HFT sounds ridiculous to me. They are just a bunch of trading junkies, the market equivalent of crack addicts. And in the same vein, I’m not sure how to get rid of them or even if it is possible. It seems to me there will always be junkies; there will always be someone skimming a little off the top.

Somewhere in the Wynn: Is this real life?

Defenders of HFT will point to the idea that they provide liquidity. As Asness says, they make markets and allow you to buy or sell stocks quickly at prices very near where they trade. The bid-ask spread narrows. This is a service they provide, and they should get paid for it.

Here’s my problem with that argument: Liquidity to me has always been a vastly overrated concept. Liquidity is there until it isn’t. When markets lock up, liquidity evaporates. When everyone wants liquidity, it disappears.

Besides, back in 1960, when the annual turnover in the stock market was 14%, nobody complained that there wasn’t liquidity. I quote from the wise Louis Lowenstein and his excellent (if forgotten) Sense and Nonsense in Corporate Finance:

“In 1960, when investors were holding their stocks for seven years on average — the reciprocal of 14% turnover — they did not expect to sell at a moment’s notice. Despite the larger spreads, their total trading costs were less, not more.”

Liquidity is like ice cream on a summer day. You want some, but you don’t need a freezer full of it.

Of course, Lowenstein reveals a way you can skirt this whole issue. You simply invest long term. I’m not saying you have to hold stocks for seven years. In this hyper-short-term market, I think looking just one year out will give you an edge.

Those who want to swap stocks at HFT speeds are not informed owners. They rent; they don’t own. And I think they make for a worse market — a market full of aggressive speculation that impedes the sensible management of the nation’s companies.

It is this kind of nonsense that turns the market into a casino. The billionaire Mark Cuban made this point on his blog in what I thought was a pretty sensible piece on HFT. “What is the definition of a rigged market?” he asks. “When you are guaranteed to make a profit. In casino terms, the trader who owns the front of the line is the house. The house always wins.”

He overstates his case. (Profits are not quite guaranteed. HFTs do lose money sometimes, and can go bust. Then again, so do casinos.) But the general analogy holds.

So what do you do?

I think my answer is already implied in the discussion above. And it’s easy as pie. You simply don’t play that game. You should invest for the long term. You should aim to know the value of what you are buying, something the HFTs don’t care about and don’t know. To do otherwise is, to borrow from Peter Lynch, like playing poker without looking at the cards.

For all the above, I have to say that Lewis is a skilled writer and a wonderful storyteller. You will probably enjoy the book. It gives you a look into a bizarre world where firms fight over milliseconds of time.

It also reinforces the idea that lots of people on Wall Street don’t care about playing fair and they don’t care about you. If you give them the chance, they will skin you like a filet of salmon.

Regards,

Chris Mayer
for The Daily Reckoning

Ed. Note: When faced with a “rigged market” – if you accept Mark Cuban’s definition – it helps to have someone in your corner, showing you the best ways around it. And that is exactly what Chris Mayer does for thousands of loyal readers. For exclusive opportunities to get all of Chris’s great investment advice – and plenty more, besides – sign up for the FREE Daily Reckoning email edition, right here.