High frequency traders, bank & broker facilitators and how they rip off the small investor

Chapter 23

High frequency traders, bank & broker facilitators and how they rip off the small investor

Source: http://en.wikipedia.org/wiki/High-frequency_trading

“High-frequency trading has taken place at least since 1999, after the U.S. Securities and Exchange Commission authorized electronic exchanges in 1998. At the turn of the 21st century, HFT trades had an execution time of several seconds, whereas by 2010 this had decreased to milli– and even microseconds. Until recently, high-frequency trading was a little-known topic outside the financial sector, with an article published by the New York Times in July 2009 being one of the first to bring the subject to the public’s attention

In the early 2000s, high-frequency trading still accounted for fewer than 10% of equity orders, but this proportion was soon to begin rapid growth. According to data from the NYSE, trading volume grew by about 164% between 2005 and 2009 for which high-frequency trading might be accounted. As of the first quarter in 2009, total assets under management for hedge funds with high-frequency trading strategies were $141 billion, down about 21% from their peak before the worst of the crises. In the United States in 2009, high-frequency trading firms represented 2% of the approximately 20,000 firms operating today, but accounted for 73% of all equity orders volume.”

Another source: http://www.financialsense.com/contributors/michael-shedlock/high-frequency-trading-hails-its-first-billionaire

The preceding paragraphs might be a bit confusing to most of us, especially if we are only casual investors. Simply stated, high frequency traders sit in the middle between traditional buyers and sellers. They pay banks & main line brokers for information on the prices at which traders are willing to transact. They look for spreads and buy and sell in microseconds. If you want to understand how this is possible, read “Flash Boys” by Michael Lewis. They make a very, very small margin on each transaction, but they do almost ½ of all the volume, so their profits are huge. Keep in mind that all of this is legal, the ethics are another issue. In my view this is the ultimate in inside trading, but there are arguments on the other side.

The HFTs pay banks and brokers for access to their bids and asks and further pay to be close to the computer processors and thus enable them to see the transactions faster and trade as fast as possible. You might ask why does it matter since they are only ripping off such a small portion of each transaction each time and both the buyer and seller will get what they want. However, this is only true for some “limit” orders, not for “market” orders. Because of their ability to see so many orders they can still match a limit order on one side with a market order on the other side. The bottom line is that ordinary traders are paying for their profits.

How much can this amount to. You only have to look at one day’s trading to figure this out:

An average day of trading volume on the NYSE is approximately $55 billion. Assume that HFTs are involved in 40% of these (and evidence is that this rate could be low), then their volume would be $22 billion. If we assume that their margin is only .1% then their daily profits would amount to $22 million. Keep in mind that this is only one exchange and the LFTs work all the markets. If we assume 250 trading days then their profits would amount $5.5 Billion a year just off the NYSE!