On the way back from Vegas a couple of weeks ago, I finished Flash Boys, the newest book by Michael Lewis. In it, Lewis tells the tale of a former Royal Bank trader named Brad Katsuyama, who figured out one day that the stock market was rigged. He concluded that certain high frequency traders were getting the order a few milliseconds before the rest of the market, and that gave these traders an advantage over the rest of the market, since they would own these shares for a fraction of a second before flipping them to the intended buyer, and take a very small profit for doing so.
Let’s look at an example, Bank of America. The current share price is $15.25, so a typical bid and ask spread would be something like $15.25-$15.26. Somebody sends in a sell order for $15.25. The high frequency trading algorithm sees this order come in, buys it for $15.245 (which it can do, if it’s a market order), and then immediately flips that order to the person it knows is waiting to buy shares at $15.25. The high frequency trader makes half a penny per share and takes on no risk. It doesn’t sound like much, but it adds up to millions if you do it enough times.
This lead Lewis (and Katsuyama) to conclude that the stock market is rigged.
Most investors don’t know this, but very little U.S. trading is done on the New York Stock Exchange. Mostly it’s routed through other exchanges, which are basically just a bunch of servers sitting in a warehouse somewhere, mostly in New Jersey. That’s a very New Jersey thing, servers in a warehouse. High frequency trading companies set up their servers as close as possible to the exchange’s (often in the same building), so they have access to the information a few milliseconds before it travels back to New York or to Nelson’s pad. The average person has no idea this is going on because it happens so quickly that our eyes or brain can’t process it. It just looks like random movement.
Not only are the exchanges okay with this, but they sell the prime spots in their server warehouses to high frequency traders. There’s a lot of risk free money to be made if one firm is at the front of the line.
For retail investors, this isn’t such a big deal. Shaving off half a cent off your 200 shares of Bank of America isn’t really worth a high frequency trader’s time. It becomes insanely profitable if somebody is trading 200,000 shares. So while it doesn’t hurt you if you buy individual stocks, it might affect the big mutual funds and ETFs that hold the retirement savings of the other group of retail investors who don’t buy individual company shares.
Katsuyama thought this wasn’t fair, so rather than fighting fire with fire, he went another direction. He left RBC to open up his own exchange. His exchange wouldn’t allow high frequency traders special access, and would intentionally delay orders a few milliseconds so all traders would get access at once. It’s his way of evening the score.
And (SPOILER ALERT), in an interesting twist, it was Goldman Sachs, Wall Street’s version of Satan, who has been the first big firm to embrace Brad’s new exchange. Currently the exchange is surviving, but that’s about it. Most orders are still being routed to the other exchanges. Should I have put the SPOILER ALERT earlier? Eh, who cares. It’s a good book. You should read it.
Anyway, how does this affect you and your trades? It really doesn’t.
There’s a really easy way for retail investors to ensure they aren’t getting screwed by this. Just use limit orders. If you tell the market you’re only willing to pay $15.25 for Bank of America, you’ll either get it at that price or you won’t get any at all. A limit order ensures you pay exactly what you want.
But even if you use a market order to buy, say, 400 shares of Bank of America and pay $15.26 instead of $15.25 like you intended, you’re still out a whole $4. It’s less than 0.1% of your original purchase price. $4 might get you a fancy Starbucks beverage, but in the scheme of things it matters less than what side I butter my toast. Even if you only buy 100 shares, it’s less than 0.4% of the original investment. If those percentages are going to make a difference in your long term returns, you’re doing it wrong.
Should high frequency traders be banned? I’m not sure. I am sure that Lewis glossed over a big benefit of the practice, and that’s the effect its had on commissions.
There’s basically only one reason we’ve witnessed trading commissions fall from $29 to $5 (thanks to the fine folks at Questrade and their $5 trades, sign up now)over the last decade, and that’s technology. And high speed traders have been big investors in new technology, albeit with an agreement that they’d get to use proprietary information. That’s a bigger advantage to retail investors than losing tenths of a cent on trades sometimes is a disadvantage.
There’s also the argument that high frequency traders provide liquidity to the market, which is true, but isn’t as beneficial as the high speed traders want you to believe. There’s plenty of volume in most North American stocks for retail investors. Bank of America trades an average of 105 million shares per day. Your 400 shares is the equivalent of the molecules inside a drop of water into a swimming pool. Congratulations, we don’t matter.
Is the stock market rigged? It depends on your perspective. From my perspective, it’s pretty easy to work around high frequency traders. If you’re a big hedge fund, you’d probably think differently. I can see how that’s a problem, and perhaps it needs to be addressed, but I wouldn’t go out and say it’s as big of a problem as Lewis thinks.