High Frequency Trading solution - 04/07/14

  I talked about HighFrequency Trading today on the air. Critics describe it as legal frontrunning. It would be illegal if it were done by humans. The fear is that if itgets out of hand, it could crash the stock market and put us back into arecession (at least).

  The way to fix it isfairly simple: make it too expensive to do it. But thats controversial becauseif the costs for conducting transactions were made more expensive for highfrequency traders, it would go up for the rest of us too.

  Heres the way highfrequency trading works. You put in an order with a financial advisor or with anonline broker to buy a stock, and the electronic signal goes from Wall Streetto the various exchanges where the transaction occurs, usually across the HudsonRiver into New Jersey. But before it gets to the exchanges, high frequencytraders put computers with fiber optic cables right in the path of thosesignals " and front run your trade.

  Following complexalgorithms that happen in fractions of a second, the computers will buy thestock you want and sell it to you at a slightly higher price than they boughtit so they make a very small profit. But they conduct these transactionsbillions of times a year, so the profits are enormous " and the increased costis picked up by you and me and anybody else who inadvertently trades with them.

  The reason its costeffective is because stocks trade by pennies now. That means the spread, thedifference between buying and selling a stock, can be so small that its measuredin pennies.  You might be able to sellyour stock for $49.97 and buy it for $50.00. That means theres only adifference " a spread " of 3 cents. Like the old joke " how do you make moneyon that? Volume.

  If you were to goback to forcing a spread of at least a nickel for each trade, the potential profitin each trade would practically go away. The stock market traded for years infractions: sixteenths, eighths, quarters, etc. A sixteenth of a point doesntsound like much, but its more than 6 cents. When the stock market startedpricing in pennies, that spread fell to one cent. (That doesnt mean that astock you buy or sell will have that small a spread, but in highly tradedstocks, it could.)

  Critics of thatsolution say the costs would go up for everybody, and that would be inherentlyunfair to all of us, whether individuals or institutional customers likepension funds investing for retirement.

  The JusticeDepartment, the FBI, Congress and the SEC are all investigating high frequencytrading now. There will be many solutions proposed, but taking away the profitmotive for high frequency traders will certainly be one of them.

 

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Last Update on July 24, 2014 10:55 GMT

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