There’s an underground investment world lurking in the bowels of Wall Street’s biggest firms. It’s a world that the vast majority of investors have never heard of — and its participants could be pillaging your investment profits on a daily basis.

That said, there’s a way out for smart investors… I’ll tell you what it is in a minute.

High-Frequency Trading (HFT) is a not-so-new trend that’s been causing a frenzy among the minority of investors who have heard about it. With HFT, firms use sophisticated computer systems to analyze markets and execute trades at ultra-high speeds — sometimes in a matter of nanoseconds.

These systems make money for their firms by making a very small profit on a very high volume of stocks. That adds up to a lot of money… some estimate that firms like Goldman Sachs, one of the leading firms in HFT, make up to a quarter of their profits from high-frequency trading.

And all of that activity has a big effect on individual investors.

It’s estimated that in 2009 HFT accounts for approximately 50% of transactions on exchanges like the NYSE and NASDAQ. All of that volume has monumentally increased the volatility of stocks according to a recent whitepaper on toxic equity order flow by Themis Trading. “Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year. Recent spreads on S&P 500 stocks have doubled compared to earlier in the year,” the paper explains.

That’s a frightening statistic when you consider the fact that much of the downside in that 4% price swing is being absorbed by investors who aren’t sophisticated enough to counter the big firms. But that’s not the whole story…

While most investors are familiar with major stock markets like the NYSE or NASDAQ, did you know that there are a number of other exchanges out there, like the Boston Stock Exchange, the International Securities Exchange, or the BATS Exchange? That’s not to mention the Electronic Communications Networks (ECNs) and dark pools that act like under-the-radar clearinghouses for big firms who want to keep their trades hidden.

There’s nothing nefarious about these alternative exchanges or firms’ desire to keep their trades away from predatory traders –- but when you consider the fact that these off-exchange trading options account for nearly 75% of the volume of NYSE stocks, it’s disconcerting to think about just how much impact these underground trading options have on the prices of the stocks that the vast majority of regular people invest in.

The Unfair Advantages of HFT

Access to underground exchanges isn’t the only unfair advantage that high-frequency traders have. They also have faster execution speeds thanks to a growing trend known as co-location.

With co-location, firms get to rent server space right next to the servers that process trades for the exchanges themselves. And it’s becoming big business for the exchanges, which are hungry for more revenues in this era of increased competition. The New York Stock Exchange is currently in the process of building two cutting-edge trading hubs -– one in suburban New Jersey and another just outside of London –- at a price tag of $500 million.

That closeness to the exchange’s servers only gives HFTs an edge of a couple nanoseconds –- but for firms who measure their trades in microseconds or less, that’s a hugely valuable advantage. Up to now, the SEC hasn’t stepped in to regulate the practice of co-location.

Another unfair advantage of high-frequency traders is the way they make profits. While there are a number of different kinds of HFTs (including liquidity rebate traders, automated market makers, program traders, and predatory algorithm traders), each with their own profit strategy, the method of choice often either involves making marginally unprofitable trades in order to collect a larger “rebate” from the exchange or legally tricking other large players into buying recently-bought shares at a higher-price.

While many proponents of HFT argue that firms who trade at these volumes add a lot of liquidity to the markets, the fact remains that the liquidity they add isn’t healthy – it’s often mispriced because of market information asymmetries that big firms (and smaller, more aggressive firms) can take advantage of.

The Secret to Avoiding HFTs Pitfalls

If you’re nervous about the impact high-frequency trading will have on your portfolio, don’t be. There are a couple of things you can do to avoid getting bitten by the big program traders.

First, do your homework. Using solid fundamental analysis gives you the advantage of qualitative, not just quantitative, research. And know that on an individual level, the effects of HFTs on your trades are incredibly small. As long as your share price is justified by a strong investment case, you have nothing to worry about.

Another way to avoid HFT manipulation is to take a look at small-caps. High-frequency traders rely on heavily traded blue chips to make their marginal gains. When you invest in smaller stocks that stay under the radar of program traders, you can discount any effects they have on your investments.

While high-frequency trading continues to get the financial media’s attention, it’s likely we’ll see some more much-needed regulation in the field. Until then, following these tips will keep you one step ahead of the fastest traders on “The Street.”

Cheers,
Jonas Elmerraji

August 11, 2009

Jonas Elmerraji

Jonas Elmerraji is an editor of Penny Stock Fortunes and a frequent contributor the Penny Sleuth. Jonas also occasionally writes for financial publications like Forbes, TheStreet.com, and Investopedia. He has been quoted as an investment expert in Investor’s Business Daily, Consumers Digest, and Bankrate.com among others. Before joining Agora Financial, Jonas’s held positions at an investment firm and at a “Big 4″ public accounting firm. He holds a degree in Financial Economics.

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The New York Times Unleashed On High Frequency Trading (Zero Hedge, 7/24/09)

The Day That Was - HFT's Superdominance (Zero Hedge, 7/22/09)

The HFT Debate (Index Universe, 7/29/09)

Read more on High-Frequency Trading (HFT) at Wikinvest

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