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Does HFT Harm Individual Investors?


What is the overall impact of High Frequency Trading (HFT)? Some traders believe that the use of algorithms in super-fast and powerful computers allows large hedge funds and other institutions to beat the market, implying that because these big traders can out-perform individuals, profits are unfairly gained. But is it true?

With the ability to enter thousands or even millions of trades on multiple exchanges, and in fractions of a second, arbitrage is taken to new heights. This volume of relatively small trades in large volume adds up to a lot of money.
 

The advantage comes from exploiting small disparity in bid/ask spreads between exchanges, momentarily inefficiency in pricing, and momentary changes in stock price trends. This is seen by manty as unfair. But here’s the big question: Yes, it is unfair, but does it adversely impact what you can earn in your own portfolio?


This is where doubt enters the picture.


A changing landscape


Two points: First, even with an advantage for the big traders using powerful algo systems, the individual investor probably was never impacted at all (pointing out the differences between something being “unfair” versus harming profitability for smaller investors). Second, the one-time advantage of HFT has disappeared and no longer is as factor.


It’s comparable to the auto business. When Ford began using the assembly line to mass produce cars, his operation was the only game in town. By 1909, there were 272 auto manufacturers in operation (How Did Detroit Become Motor City?)


The point is that good ideas tend to bring in more competition, a basic economic reality. And more competition means less market share to go around. This is exactly what has happened to HFT. It has become unprofitable because too many institutions are practicing this system. The overall profit pool due to arbitrage and HFT usually does not beat the market any more, as it did only a few years ago.
 

Overall, HFT-generated profits might still present a small advantage, but it is distributed over so many institutions that the algo and computer investment is not yielding the kind of profits you might expect. With too many players, the profit pool has been diluted. Consequently, the unfair advantage once enjoyed by the big institutions has disappeared.


Image result for HFT

 

Slow regulatory response


The trend came to an end so rapidly that regulators and politicians did not have time to figure out how to control or stop HFT. Among the disturbing aspects of the practice was that according to some critics, exchanges were giving HFT traders priority in trade execution. This would be disturbing if the practice was having an impact on profits for retail investors. But no laws were being broken at the time, and the popularity among institutions brought about the demise of HFT.
 

Forbes published an article on this topic in March 2017 (Don't Worry, Be Happy - High Frequency Trading Is Over, Dead, It's Done). The story points out that “HFT has gone from invention, though something many opposed, to it now being a boring and unprofitable part of the basic infrastructure of the markets. We've had the entire cycle, the entire economic technology cycle, in only a couple of decades.”


The disappearance of HFT’s advantage helps options traders, perhaps more than most others. Using options to hedge equity positions with well-timed trades, as it turns out, continues to be more beneficial than the minor profits that must be shared among many institutions.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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