Stop The Freak-Out: High Frequency Trading Is No Big Deal

Michael Lewis has written a book called Flash Boys. The basic premise of the book, inter alia, is that high frequency traders are able to profit from individuals and brokers trading stocks by moving quicker than a normal trade execution speed. Here is what I mean by this. Lewis (and many others) is concerned that Trader H can take advantage of Trader S, who wants to buy 1000 shares of Facebook. Trader H can purchase 1000 shares of Facebook and sell them to Trader S at a very small profit, because Trader H knows that there is a trader out there who is looking to make that purchase, can buy the shares, and “flip” them in microseconds. Doing this a million times a day can generate big profits over the long run.

Others also feel that there are larger risks to high frequency trading (HFT), such as the so-called “fat finger” executing a trade by mistake, and high frequency trading programs initiate multiple trades based on that error. This is possibly what caused the “flash crash” in 2010. Another issue with HFT is the production of “fake quotes” which can shift the price of a given security. If an HFT program can spit out bids for a stock that is $5.00 less than the actual price, and cancel those bids before they can be filled, the real price could theoretically drop. These are legitimate and serious concerns.

The range of reaction is from “who cares” to “it has been always rigged” to “we need to do something about it” and everything in between. These diverse opinions are all from smart people who raise good points on this issue. Where do we draw the line? We obviously want a free market, but we want to make sure that we don’t have mini or major “flash crashes” (like the image above, courtesy of either caused by fake quotes from non-bona fide purchasers, right?

The foregoins is an very simplistic overview of HFT, of course, and I am not suggesting that I am reviewing all of the potential risks in this post. However, I wanted to draft an article from the perspective of the individual investor who might be hearing about high frequency trading for the first time and is concerned about his or her own long-term investments.

What can the average, small-time investor do? Ignore Mr. Market — especially when he’s on speed.

Mr. Market is a parable of sorts told by Benjamin Graham in his seminal work The Intelligent Investor, the important part of which follows below. Here’s an excerpt from the Revised Edition 2005, page 204-205:

“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

“If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

How does HFT change Graham’s analysis? It doesn’t — if you’re a long-term investor.

Graham, who was a mentor for Warren Buffett and countless others, stands for the proposition that the intelligent investor acquires shares of quality corporations at quality prices. Does it matter in the long run if you bought Coca-Cola for $25.00 or $24.99 in 1987, for example, if your time horizon is forty or fifty plus years? Hardly. The whole point of value investing, according to Graham (and I hardly do justice to the brilliant man), is that one is purchasing stocks with a margin of safety. This means that if we think Coca-Cola is worth $30.00, we might buy it up to $28.00 and have a $2.00 “wiggle room” in case our analysis was imperfect, or to account for an unexpected market or societal event.

In the long run, if we paid a fraction of a cent more for a stock because of HFT, is that any different than if we bought a stock at a slightly higher price but still within our margin of safety? No. In fact, the long-term investor might actually benefit from HFT if the price of a given stock is pushed down to give it a larger margin of safety — or a discount to what is deemed to be a fair value.

On the other hand, if we are trading (i.e., holding the stock for a short period of time to scalp a quick profit on a movement in one direction or another), then we might be more concerned about HFT.

In essence, if Mr. Market is hopped up on speed, it should not affect our analysis as an intelligent long-term investor. We determine the value of a security based on more static things such as cash flow, assets, pricing power, profit margins, and the like. Once the price of the given security enters our “buy” range, we take advantage of that and purchase the security.

Rather than banning HFT, democratizing the technology would likely level the playing field. Thirty years ago, individuals who bought stocks had to go through high-priced brokers and usually had difficulty obtaining information other than publicly filed SEC documents, which were accessible via snail mail. Today, the internet provides a lot more information to the small-time investor.

Bottom line: there certainly are concerns with HFT, especially if non-bona fide purchasers are using fake quotes to distort market prices. Also there is concern with respect to “flash crashes” or other market moving events. Small-time traders are certainly subject to a disadvantage when trading if their margin of safety is razor-thin. However, if one does his or her homework (as Ben Graham and Warren Buffett would recommend), I don’t think investors with a long-term horizon should freak out over high frequency trading.

As always, free markets are better markets.

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The second quarter earnings season kicks off Tuesday after the closing bell, with Alcoa reporting. Traders will also be looking at initial claims (projected at 318k) and producer price index to see if inflation is starting to pick up, which might be a factor in the Federal Reserve’s monetary policy.