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Wall Street’s White-Collar “Pickpockets” Are Scalping Your Profits

Thought “Watson’s” dominant performance against human competitors on “Jeopardy” was impressive?

The super computers on Wall Street could give Watson a real run for his money. Literally.

Unfortunately, they’re also gouging “regular” investors like you and me.

Rapid-Fire Trading Creates Rapid Profits

They’re called high-frequency trading (HFT) computers – ones that buy and sell massive amounts of shares in a matter of seconds.

And speaking of seconds, the average holding time is just 11 seconds, too. This kind of trading activity accounts for about 70% of the volume on our stock exchanges now. (However, these numbers are rough estimates at best. The HFT shops are too secretive to provide real numbers.)

In terms of profits, we’re talking about a few pennies at a time here. But when you’ve got such frenetic trading activity, those profits can seriously mount up.

But that’s not the whole story. A new paper from researchers at Cornell University and Columbia University exposes another of Wall Street’s hidden lies…

High Frequency for the Big Boys… Low Profits for the Little Guys

Simply put, the researchers show the mechanism by which these HFT funds create a mispricing that they then exploit… thereby reducing all other investors’ returns in the process.

This goes against prior research, which was generally positive on HFT. After all, it gives the market a lot of liquidity. If you want to buy or sell shares quickly, you can theoretically get a better, faster fill price. Early evidence suggested that HFT reduced bid/ask spreads and decreased market volatility.

But freak events like the “flash crash” of May 2010 raised questions about how these traders affect our market.

The research paper “A Dysfunctional Role of High Frequency Trading in Electronic Markets,” by Robert A. Jarrow and Philip Protter, shows how HFT could actually create a less efficient market and reduce investors’ returns in the process.

The HFT Advantage

Essentially, the problem stems from the fact that most of these HFT firms identify the same signals – and then trade on them together. So when signals are tripped, HFT firms all pile in at once to buy or sell.

This activity changes the price of the stocks in question and creates a self-fulfilling trend that earns profits for the HFT firms.

To understand how this creates an unfair advantage, think of it in a similar way as a stock pump-and-dump scheme…

In this scenario, a nefarious outfit buys up shares of a penny stock. It then pushes out spam emails and other reports that encourage unsophisticated investors to buy, too. This drives up the price. The scammers then dump their shares at the peak, the price collapses, and average investors take a big loss.

In these cases, individual investors lose because they don’t know when the scammers are going to dump the stock.

In HFT cases, when the prices get pushed up, traditional investors like mutual funds and pension funds lose money on trades because they don’t have the technology to react in microseconds like the high-frequency traders.

So how much does this cost you?

Well, while you may not trade often, your mutual funds and ETFs do. And with each trade, HFTs skim a few pennies for themselves. Considering the effects of compounding, even a tiny drag on your returns adds up to real money in your retirement account.

So how can we stop this practice and get our money back?

The Epitome of Free Market Economics… Or Just Petty Theft?

Well, even the most free-market libertarian would say that since these firms have developed this expertise, they should be able to profit.

In this case, however, that’s like telling a pickpocket to continue stealing wallets because he’s developed the skill to do so.

But the problem is that there’s no sure-fire way to stop this practice. The HFTs aren’t mounting coordinated attacks to move prices like a pump-and-dump scheme. Instead, they just happen to have discovered the same triggers.

It would take a shift in the basic structure of the exchanges to put a halt to this type of trading. But because higher trading volume produces more money for the exchanges, I wouldn’t expect them to kill their golden goose anytime soon.

Good investing,

Matthew Weinschenk

Matthew Weinschenk