Study: High Speed Trading Hurts Long-Term Investors

Gah what a stupid article. Consider its foundational point:<p><i>"Pragma measured the effect by comparing the volume in certain stocks with the time it takes to execute an order. Longer execution times typically result in poorer results, since a stock's price can swerve away from where it was when the order entered the market. Such an effect is known in the industry as a "shortfall.""</i><p>If you are a "long term" investor you don't sell stocks to capture a few pennies here and there. You buy at price $X and hold it for a while, maybe you put in a stop order [1] so that if the shares start heading for the floor you will automatically exit. You set a value you want to see for your 'gain' and you set a limit order [2] when the stock starts getting close. The limit fires and you exit the stock. Even if it keeps rising and rising.<p>The basis for the claim in the article is that some HFT house might buy your stock when it hits the limit order price, because it is predicting it will go higher and then instantly resells it for a bit more than your price. You've cashed out already (closed your position) and they skimmed a bit of cream off the top. You didn't 'lose' any money at all.<p>For those not familiar with stock trading:<p>[1] A 'stop' order tells the firm holding your stock that if the stock drops below a certain price (the stop price) to automatically sell the security. So if you buy a stock at $10/share and you don't want lose more than 20% on it you might set a stop order for $8/share.<p>[2] A limit order goes the other way, you tell the broker that if the stock ever gets to a certain price to sell your shares. So if you are looking for a 10% return on your $10/share stock you might put a limit order in for $11/share. (or $11.25 if you want the 'net proceeds' to be $11/share).

This comment from the article pretty much sums it up:<p>"This study treats correlation as though it were cause and effect. The fact that HFTs choose to trade stocks with bid-ask spreads of two cents (instead of one cent) does not mean that the HFTs have made that spread larger. The high liquidity provided by HFT has to let anyone with a market order receive a more favorable price than they would in the less-liquid market without HFT. HFT is simply improvement of the labor of market-making through the use of machines. For the past three hundred years, virtually every mechanization which improved the productivity of labor was fought by the establishment. This is no different."

The Pragma report [1] that the WSJ refers to investigated when a TWAP algo would need to "cross the spread". Ie, when the order book is really deep, then it takes so long for a passive order to execute that crossing the spread becomes necessary.<p>This effect has nothing to do with HFT firms. In fact, the referenced white paper doesn't even mention HFT at all! So it's odd that Pragma's CEO would make such a remark to the WSJ.<p>It's even odder that the Pragma paper doesn't mention the numerous other ways of executing a passive order, such as pegged orders, pro-rata venues, low-rebate exchanges, or even crossing networks. The authors describe a totally out-dated view of how liquidity is accessed for a stock like BAC.<p>[1] <a href="http://www.pragmatrading.com/research/research-notes" rel="nofollow">http://www.pragmatrading.com/research/research-notes</a>

Not sure it still applies as I have been out the trading game for a little while now, but in the past the big HFT's had a 20 millisecond window where they were allowed to see the market orders before anyone else. Thus they could see say a big buy order coming in and pull their offers or even take out the offers themselves, knowing that the buyer would have to pay up. This has the effect of raising execution costs for the company trying to accumulate stock for their long term positions. Obviously the same techniques would apply to the long term investor trying to close a stock position by selling.<p>This was effectively legalised front running of the market, something that would normally get you sent to jail. In the name of liquidity, exchanges allowed this and of course they got paid big bucks by the big HFT firms.<p>The whole trading game is pretty corrupt. You would expect that given the amount of money sloshing around. For example we knew about market manipulation in LIBOR for many years. It was an open secret but now the regulators are "discovering" it because the political climate is such that fewer people are prepared to live with the big banks excesses.<p>Still there is plenty more ongoing manipulation going on in trading even as I write this. I am awaiting the day that the regulators will "discover" these. Some of the bond markets for example have proportional fill executions. So if you have the best price and are first in the queue, a big institution can come along and show an order in vast size, which they have no intention of trading, just to get a fill of the fraction they actually wanted. You of course are left high and dry with just about nothing of your order filled because proportionally it was tiny. It is an amazing sight to behold how these vast orders come along just as the market is about to move and then instantly disappear. It is clear to any trader that someone is working on inside information, but everyone (read: big money)is in on the secret so no one is telling.

I don't get it.<p>Some long term investors are placing passive orders to squeeze out an extra penny on their investments. I.e., they are running a strategy that's a mix of long term speculation and market making.<p>Unfortunately for them (but fortunately for the purchasers of liquidity), they are getting crowded out of the liquidity selling market by people who focus solely on selling liquidity.<p>What's the problem here?

An analysis of who makes profits when HFT's trade. <a href="http://www.nanex.net/aqck2/3519.html" rel="nofollow">http://www.nanex.net/aqck2/3519.html</a><p>an interesting analysis - results towards the end "The Final Score"

<i>long term traders have trouble quickly buying and selling the stocks.</i><p>If you're a long term investor, and the particular minute of the day when you make your transaction makes or breaks your strategy, then you were effectively just flipping a coin with your long term strategy.

To come at this from a slightly different angle.. any situation in which an agent gains wealth without creating wealth is at the expense of the market.<p>Two questions, first are HFT's creating wealth? second, are HFT's gaining wealth at the expense of the investors or the producers?

It seems to me that the 800lb Gorilla in room is the impact of HFT on volatility which is not really covered here.

We should really tax all stock trades at .001% or something.