Market Beat: What’s up with high-frequency trading?
September 26, 2013
High-frequency trading, or HFT, is a relatively new development on Wall Street. I often have investors ask me what high-frequency trading is and if it affects their investment portfolio. Today, high-frequency trades account for more than half the volume on the exchanges.
High-frequency trading is the rapid fire execution of stock trades done by sophisticated computers using advanced algorithms on the millisecond level. A millisecond is one thousandth of a second.
To illustrate how important speed is to high-frequency traders, just take a look at the following example. Within the last couple of years, a firm spent hundreds of millions of dollars to complete a data pipeline from the major exchanges in Chicago to New Jersey. By routing the line straight, instead of along roadways, over bridges and through power lines, they were able to shave about 3 milliseconds off the time it takes for the data to get from an exchange in Chicago to New Jersey.
If 3 milliseconds didn't make a difference to these high-frequency traders, they wouldn't be spending hundreds of millions of dollars constructing a pipeline just to save an average of 3 thousandths of a second for the trade to execute. Now there are plans to build a similar pipeline that will connect New York and the exchanges in London. I believe that will cost about a half billion dollars or more.
The regulators are increasingly concerned about technical glitches that have plagued some exchanges recently including the "flash crash" of 2010 where the Dow dropped more than a thousand points in a matter of minutes only top recover the same day.
High-frequency trading has some beneficial effects for the average investor. The liquidity provided has lowered bid/ask spreads to a penny for stocks with high volume. Commissions have also come down over the last few years.
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In my early days as a stockbroker, I had to hand write a trade ticket, then take the ticket to a wire operator who sent the order to the exchange. Commissions at full service firms could be as high a $100 per trade, and before decimalization, the bid ask spreads were in fractions and they were high.
Today, a small investor can place trades from their own computer for very low commissions, have tight bid/ask spreads and get rapid fire trade execution. Investors who use options as part of their strategy have an advantage over large institutional traders because the small trades are easier to execute.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information on his money management service can be found at his blog at http://www.sellacalloption.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
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