April 21, 2014

Are the Markets Really Rigged?

Summary

It is easy to understand how people could be lulled into believing markets are rigged. Someone always seems to have more or better information about investments than you, and markets are prone to ups and downs. However, for individual investors in a competitive market, HFT will have very little impact on your bottom line. Instead of concerning yourself with HFT, create a long-term investment strategy and stick to it, don't try to time the market, and invest with a firm that charges low management fees. Handling these factors poorly will cause more harm to your portfolio than HFT ever will.

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Perched atop the New York Times best-seller list for hardcover nonfiction, a new book is igniting a firestorm of debate. Michael Lewis' "Flash Boys: A Wall Street Revolt" explores the relatively obscure phenomenon known as high-frequency trading (HFT), leading some to believe that the markets are rigged. But markets are not rigged, and Lewis' book itself actually demonstrates why. Despite widespread media attention, average investors should not be concerned about the HFT hullabaloo.

The first thing to understand about HFT is that it occurs primarily between large firms and does not compete directly with individual investors. It is within these large firms that Lewis' book is set. He tells his readers how HFT and the computer programs behind it - called algorithms - are much better at finding trading opportunities than human traders. That should come as no surprise; computers make most of the things we do faster and more efficient. Financial markets are no exception, and it would be a mistake to ignore the potential economic benefits that HFT can provide.

Lewis goes on to recount the story of Brad Katsuyama, a former Royal Bank of Canada trader, who became frustrated by his inability to beat high-frequency traders to a particular stock price. He developed his own algorithm to resolve this problem, which timed his orders in such a way that he could purchase the stock before the faster high-frequency trader did. Katsuyama accomplished this by slowing down the speed of his trades and changing the way they were routed through the various exchanges.

While the actual process is complicated and difficult for most people to understand, the fact that Katsuyama was able to do it at all demonstrates that markets are not rigged. If they were, no one would be able to create an algorithm that could effectively compete with a high-frequency trader. In other words, markets are simply competitive, and traders just need to find the right strategies to compete.

A second indication that financial markets are not rigged is that Katsuyama was able to establish a competing trading venue - IEX - that has its own set of trading rules designed to take away any speed advantage HFTs might have on other venues. By creating IEX, Katsuyama found an additional opportunity to compete, again indicating markets are not fixed.

So, if markets are not "rigged" as Lewis suggests, why should HFT competition concern the average investor? It shouldn't. HFTs are only responsible for about 48.5 percent of daily trading volume, so the majority of trading volume is, in part, controlled by individuals like you.

While markets have gotten faster and more competitive between large investment firms, they aren't trying to compete with people sitting at their kitchen table, buying and selling stock through their online trading account. The reason you can make a stock trade for less than $10 is because the competition created by HFT drives transaction costs down. Most investors continue to buy and hold long-term mutual funds in retirement accounts, and there is no reason to change that strategy. The microsecond activity of high-frequency traders won't harm your long-term investments. In fact, HFT helps you by ensuring there is a buyer available when you are ready to sell.

It is easy to understand how people could be lulled into believing markets are rigged. Someone always seems to have more or better information about investments than you, and markets are prone to ups and downs. However, for individual investors in a competitive market, HFT will have very little impact on your bottom line. Instead of concerning yourself with HFT, create a long-term investment strategy and stick to it, don't try to time the market, and invest with a firm that charges low management fees. Handling these factors poorly will cause more harm to your portfolio than HFT ever will.