Investors deal with high frequency trading

What you learn from this lesson: Investors deal with high frequency trading

Investors learn the strategy superior investors use to deal with HFT. The lesson begins with an outline of how HFT affects investors. Then covers how small investors can deal with HFT using their advantages. Third, investors are advised to recheck their scam and fraud defenses. And finally, when trading, investors learn the benefit of set price orders to avoid the greatest amount of HFT impact.

By using this strategic thinking, successful investors have an edge when dealing with HFT. You can learn to know and understand how investors drive superior results by playing their advantages over traders and HFT schemers. Using small investor advantages and placing set price shielded orders you can keep most of the HFT effects out of your portfolio.

How high frequency trading affects investors

Building on the background from the earlier lessons, investors need to know how HFT can directly affect their trading. Part of becoming informed about HFT means accepting this fact of financial life. As such, it affects you and every investor. That means HFT affects the wealth of investors who have never heard of it or know what it is!

At least in that way, you are ahead of most investors. But all investors suffer the HFT market impact of being deprived of fair unmanipulated prices. That manipulation occurs when investors buy or sell. It happens because HFT can read your order, front running it and bump your costs. And that difference gets put into their pockets. 

In addition, the effects of HFT include increasing volatility and market turmoil, two causes that undermine investor confidence. With undermined confidence, risks increase. That directly raises the costs of capital.

That is an example of HFT raising the cost of capital while spreading those increases across markets. Those higher costs get applied like a layer of tax across markets.

Like all costs, costs smeared thinly across markets get passed to consumers. As a result, HFT not only increases risks, but undermines investor confidence with their predatory front running trades while picking investor pockets. 

But all the news is not bad. For example, in response, an individual investor can use strategies that avoid most HFT impacts. By learning and adopting those strategies, anyone holding stocks can dull the effects of HFT. That can improve their trades and portfolios. However, in the case of pooled funds, the story is less cheerful. They have fewer options and few choices.

High frequency traders target pooled funds

Funds and other pooled assets are the prime HFT targets. HFT puts crosshairs on every pooled asset trade they can find. Those orders are the main course in their feeding plan! Large fund orders are the feed for HFT. That has the effect of driving up costs for fund owners and buyers. 

Those fund buyers have limited options to protect their money from HFT predators. In such cases, the best an investor can do is adopting a strategy to concentrate their holdings in low turnover funds. In fact, that is about all they can do.

That is unfortunate because , by far, the majority of investors hold pooled assets that are affected by HFT. Those assets include mutual funds and institutional funds. Pooled asset funds also include public or national pension funds, mutual funds, ETFs, private pension funds and a vast number of other institutional funds. Those funds, as well as the owners and beneficiaries, suffer direct negative cost effects from HFT activities.

HFT has a direct impact on every pooled asset fund that trades or owns any traded component. That includes funds owning those components such as stocks, bonds, currencies and commodities. All are affected by HFT because markets used to trade them allow these computerized predators to feed on investor orders.

Price stability and costs impacted

Those impacts include both the price stability and costs the funds feel from HFT activity. Because the large funds are the prime target of the program trading predators their activity has a direct impact on fund costs. Owing to those increased costs impacting all funds affecting payouts that passes those costs on to any fund buyer or beneficiary.

Through front running, HFT picks the pockets of those investors one slice at a time. That action affects market stability and volatility. And that directly affects and often unsettles investors which damages the market stability and honesty. HFT action makes markets more dishonest. 

To minimise those impacts there is one basic strategy fund investors can use. That strategy gets buyers to focus their purchases on funds with the lowest turnover ratios. Those low turnover ratios will put a limit on the impact HFT costs have on your wealth.

Pocket picking by high frequency trading

Individual investors wanting to do more begin by understanding how HFT play their orders. Previous lessons of this course, High frequency trading explained, deliver the details on how HFT works. For an individual investor, it can help to have an example of just how this could play out with their orders. 

To do that we can use make up examples using a made up stock named NewCo for our subject. For clarity, this example is made very simple to show the basic price manipulation while ignoring the variables involved.

NewCo trades at $10.05. In that case HFT sets up an ambush to jump any buyer or seller. HFT owns no shares of NewCo but places orders to both buy and sell NewCo. The bid to buy NewCo appears at $10.04 and an offer to sell appears at $10.06.

How high frequency trading rips off buyers

So first, investor A, sees the bid and offer prices and decides to buy the shares offered. So A expects a market order to be filled at $10.06, places that order. 

The instant they hit the key to buy, but even before their finger lifts from the key, several things happen:

1. The HFT algorithm sees the order,

2. The HFT cancels their offer to sell at $10.06,

3. The HFT places a new offer to sell at $10.07

4. The market order to buy gets filled at $10.07.

Before any investor can react or even see those changes, the market order gets filled at $10.07. As a result HFT picked the pocket of investor A for a penny!

How high frequency trading rips off sellers

At the same time HFT plays the opposite scenario to pick the pockets of sellers. To demonstrate that, here is what happens on the selling side. In that case, our seller, investor B places an order to sell at $10.04. They hit the key placing the order.

As before, the instant the order got placed, but before it sells, several things happen:

1. Again, the HFT algorithm sees the order,

2. The HFT cancels their bid to buy at $10.04,

3. The HFT places a new bid to buy at $10.03

4. The market order to sell gets filled at $10.03.

As with the buyer, in the case of the seller, before any investor can react or even see the change, the market order clips a penny. The sell order gets filled at $10.03, picking the pocket of investor B for a penny.

Nothing in, nothing out but clipping orders all day

In our story, HFT begins and ends the day with no inventory. They put nothing in, clip investor orders all day to take a slice and leave nothing behind. In between the opening and close, HFT algorithms can clip phenomenal volumes of orders at 30,000 times a second!

Doing that HFT can continually pick pockets by both buying and selling investors for tiny gains. That quickly grows to millions of transactions for shares of many companies across markets.

Our example is simplified to make a most basic point. The volumes traded are huge. But pennies clipped from investor orders soon add up to millions in profit. The example lays out one basic strategy. There are many and ever growing thousands more HFT strategies. 

Investors respond to accept change

Because HFT changed markets and investing, investors must accept these changes as facts. And most importantly, they must respond by changing how they invest. Accepting that HFT has changed markets and investing is not approving what has happened. But it does acknowledge the reality.

Regulators, exchange managements and inside players long ago tossed out transparency, fairness and a level playing field. So investors wanting to protect their investment results, must take their own action.

Doing that by changing how you respond to the HFT changes, can put or keep more money in your investing pockets. That means learning the best way to place orders and trade. 

Do not for an instant think that you can play, let alone win at the HFT speed game. You can not. Any human thinking they can beat a computer is naive or simply without judgement.

Second step:
Investors deal with high frequency trading: superior investors use their small investor advantages

For starters, be you and commit to being an investor. You can win at that but you can’t win in any contest to trade faster or smarter than HFT. Especially forget any notion that you can day trade and win. There was a time. In fact, I did it successfully, but that was long ago. That ended when HFT came upon the day-trading scene and handed us all our heads.

You can’t be them or beat them at their game so don’t try. But you can win by investing so start with your advantages. To begin, in investing, small is relative when big starts at a billion! Yes, even investors managing millions are small players in the multiple trillion dollar investing universe. And that big, small time investor, like all other small investors, has and retains important advantages over big institutions and investment funds.

Those small investor advantages include even the smallest investor or a beginner. Of their advantages, flexibility is first, because small can be quick. And that nimble, maneuverable advantage can be played in shallow or deep markets across a broad spectrum of stocks. No large fund can do the same or have anywhere near as many choices.

Small is fast, free to play and flexible in timing 

Small investors can make those flexible plays without concern about changes in the makeup of any index or fund. As small investors we can be less concerned about rebalancing, splits or spin offs. We can all play our advantages in all circumstances. Unlike the large funds, small investors have no need to follow a fund charter or feel pressure to meet the agenda of management. Small investors can operate free of any benchmark code.

Because of their flexibility, small investors can step in or out of any market. As well they can accept or pass on any investing play. Likewise, investing selections and timing can be made or not without restriction.

Among the greatest small investor advantages is the ability to move fast. Speed of action and decision making free of any need for a committee or management meeting or approval is unmatched by large funds.

Smart investors get rid of costs to build wealth

Without doubt the greatest small investor advantage is the possibility of operating at very low cost. That means small investors have the option of avoiding high money management fees. Unfortunately, high money management fees take half and more of the gains made by investor capital. The financial service industry stoutly resist making any meaningful changes in these high cost money management fees.

This one optional advantage makes the greatest wealth making difference over the long term for investors that take it. Only small investors have the option of using this advantage.

Taking advantage of this option requires a small investor to be able and informed. That requires them to learn how to manage and control their investing assets. 

The most basic and simple response is to set up a portfolio of diversified index funds or low cost ETFs. Doing that assembles a low cost investment portfolio delivering long-term returns. It is a case of getting the costs right. Among the most basic of investing facts is the constant, you can’t pay too much. Doing that produces a low-cost winning investment portfolio.

Investors have strategic thinking advantages

Investors dealing with high frequency trading also have strategic thinking advantages over huge funds and an important edge over traders. Investors can play those advantages to minimise the impact of HFT on their portfolio and trades.

Why our trades are not attractive to HFT

We can make our trades unattractive to HFT. Small investors, even those running multiple million dollar portfolios,  don’t trade large enough orders or often enough to be attractive HFT targets. Our largest orders are small potatoes compared to the orders of large fund managers. Those large fund orders are the market rigging focus of HFT.

Included among those large funds targets are the orders of investment funds, mutual funds, hedge funds, ETFs and so on. Their order totals are for tens of thousands or more shares. As HFt needs high trading volumes, ideally of larger order sizes, to make money, our small orders can slip by unnoticed. Any small investor trades caught by HFT are mere collateral damage. 

Even though we are not the prime target, HFT, as always, are happy to pick our pockets. But because they focus on finding big orders from big funds, we have an opportunity. We can set our orders up to avoid being their prey.

By doing that, small players in the financial world can set up trades that avoid HFT predation. When played well, our trades avoid the HFT clutches. That makes our ability to set up orders as unattractive HFT trades, another small investor advantage.

Slowing down high frequency traders

We have no hope of outracing HFT but we can trip them up by slowing down. Tripping HFT speed means using speed against them by trading slow. That works because to maximise profits, HFT must trade in volume at high speed. We avoid that mix by trading slow. 

By placing slow trades, investors can be used to out think and out play HFT. Doing that we give them no attractive trades to pick off. In short order, HFT will simply ignore our small time action while continuing to prey on large fund  trade orders. That makes trading slow another small investor advantage.

Third step:
Investors deal with high frequency trading: scam and risk guards on high

Any advisor telling you HFT has no affect on your account, should immediately be fired. Any such advisor misinformation costs you by letting your pockets get picked. You can no sooner flap your arms to fly than you can outrace HFT with any trade or order. Any race with HFT is over before we even begin a trade. 

So, to protect ourselves, we need to change how we place and manage orders. When making changes in managing investments you must be aware of the need for risk management. Beside the HFT risks there are other market risks we must approach with a defensive mind.

Scam Alert!
Counter algorithm cons are loose

Be aware of the counter algorithm scams. There are several offers of trading technology or services that promise hardware, software or services that give you the trading speed and power of HFT. There is no way for any device, program or service to turn you into a HFT powerhouse. Those false promises only intend to rip you off. Just pass.

There is absolutely no way your or my desktop, laptop, tablet or phone can get anywhere near the speed and access of HFT. Don’t waste a moment of time or any money on such scams. Doing so will quickly provide a refresh er of the long established wisdom, a fool and his money are soon parted.  

Avoid stop-loss fallacy & STOP hunters

We want to avoid losing money but must not fall for the stop-loss fallacy. A stop-loss can give a false sense of security. Worse, it can paint a target on your order and invite a loss. 

When they are used, stop-losses are automatic trade orders placed at a price below the current market price. For example, the order tells your broker to sell your shares if the trading price falls to the lower price. In theory, if you set a stop-loss order 10% below the current price, the shares would automatically sell if the market falls to that price. Some investors place a stop-loss order 5% away from their trading price.  

Stop-loss orders sound so good! And offer an easy way to protect your investments and orders...maybe! That is when done right. But without being aware of how to use a stop-loss well, investors can set up stop hunter targets.

However, exposing orders to stop loss hunters all but guarantees you a loss. How can something that sounds so good turn into something so bad? In theory stop-loss orders can prevent big losses on your open stock positions. But with HFT infecting markets, that has changed. In fact, stop hunters have always preyed on the stop loss orders of naive investors. 

Here is how that works. When an investor sets a stop-loss market order, that order turns into a market order when triggered. However, the big risk that comes with such an order is that the price taken can be much lower than the trigger price. And yes, this can and does happen on a daily basis. 

Algorithmic trading pushes volatility

HFT worsened volatility can hit investors with huge losses. The 5% stop-loss fallacy. Placing or setting stop-losses at 5%, 10% or milestone prices invite losses. Price gaps are regular occurrences for no or very good reasons. 

In either case your stop-loss trigger gives you stock away at lower prices. Then a quick rebound leaves you on the outside looking in. Those needless losses simply pick your pocket 

Predators jump stop-loss limit orders

Don’t fall for using a stop-loss limit order to avoid the market order loss problem. The limit order sets the price you are willing to accept. While setting the sale and trigger price at the same seems reasonable. That sets up another problem. That problem occurs if there are no takers at your price. In that case, nothing gets sold. And that often happens when prices spike down, the next sale can be well below the price you want. As a result, you end up with a very low price or alternately, your acceptable price gets jumped, leaving you high and dry. And well behind the market. 

Advisors recommending stop-loss orders are only helping themselves. Such orders are not good for you or your wealth. After all, they do appreciate the commission! But you get ripped off! I do not use stop-loss orders because they do not work. Investors using stop-loss orders have lower returns.

HFT & stop-hunters see more 

Both HFT and stop-hunters pay to data feeds that let them see what you can't. In transparent markets stop-loss orders are visible to these predators. Set stop-loss orders sit like little signs saying take my money! Remember, for higher data fees, HFT and other professionals traders get more and faster information than you or I get or need. 

Yes, you can buy that rich data feed as well, but you have no need to pay the high fees for that data. Even if you are running a very large individual account, you can not afford it! Only those who profit from that data by making thousands of daily profitable trades, profit from it. 

The rich data feed allows them to see all our orders including the stop-loss orders any investor has set. Stop-hunters see those orders as easy pickings to bag. With a few keystrokes a HFT algorithm can be programmed to spike prices up or down as needed to trigger stop-losses. 

Also, remember, as noted earlier in Lesson 11, HFT misinformation and HFT are market constants investors must be aware of.  HFT routinely induces conditions for flash trades. Flash trades happen and they happen fast. They can sweep through the stop-loss orders and carry on without missing a beat.

As a result of such trades, prices can spike prices up or down to trigger any stop-loss orders. When that happens stop hunters, traders seeking to pick off poorly set stop-loss orders feast on easy prey.

Stop-loss orders and careful price sets

Two poorly set stop-loss prices are most common. First is setting the price at a milestone amount. Most obvious are round dollar amounts but major fractions like a half or quarter are also poor stop-loss price choices.

Second, is setting a stop-loss price at simple amounts rounded up or down from a milestone or regular price supporting a stock. The most common set amounts are an even 5% or 10% up or down. Rather than doing that, back away from such prices to avoid HFT or stop hunter actions. 

HFT and stop-hunters can dip to pick off stop-orders only to immediately return to higher prices. That leaves you selling cheap and on the outside watching as markets again rise.

Stop-loss proof is research nonsense

Believing bad research can cost you money! So stop with the bad stop-loss research! We just can’t believe everything we read, especially bad academic studies. While academic studies can help our understanding of markets and investing, poor academic work is far too common. 

Most frequently the fault with poor academic work lies in bad study design. Attempts to isolate one factor for study can involve using a computerized model of the market. That intends to show outcomes from that one factor. However, doing so in an artificial world may not produce useful information for use in the real world. 

Models, essentially computer programs, can show useful information and can also produce bookshelves full of junk research. It depends on the design of the study and how that design reflects and produces any real world information. That can be a major challenge.

For example, multiple computerized tests of stop-loss order performance assumes stop-loss orders get reliably executed at the specified price. That sounds great but is nowhere near reality. Few markets offer such outcomes as routine fills of stop-loss order at reliable prices. 

Any researcher wishing to challenge that should bring their findings to the real world. One they jump into the real world they will soon discover how real losses can add up. 

So, for any investor, rather than placing stop-losses, traders can do better by setting up their own mental loss limits and manually trigger orders as required. Set and act on price alerts rather than using stop-loss orders. That will keep your orders out of the stop hunter’s bag.

Fourth step:
Investors deal with high frequency trading: use priced not market orders

Superior investors can learn how to limit or avoid the bite from HFT predators. Do that by changing the game and using slow speed to your advantage. Once we have a target company in mind we can start the process of managing how they buy shares.