Island Investing: High Frequency Trading

Q. What is high frequency trading?

A. Five years ago, if you asked me to name two arcane financial subjects that I’d probably never hear discussed in a diner in the Keys, I’d have said ‘credit default swaps’ and ‘trading algorithms.’ During lunch at Mangrove Mike’s in Islamorada a year ago, however, I first overheard someone mention swaps. If that shocking 1,000 point drop in the Dow Jones last Thursday was any indication, you may soon become familiar with the term “high frequency trading,” too.

High frequency trading or HFT is many things – including another example of how Wall Street is more interested in being a casino than a steward of wealth. Simply put, HFT is stock trading done by blazing fast computers at Wall Street firms – some of which are located literally right next to the computers that drive the NYSE and NASDAQ. The powerful algorithms on these HFT machines can create and change orders for stock in milliseconds. It is believed that a handful of HFT firms now account for half of all trading volume on the nation’s stock exchanges.

The problem is that through loopholes in the rules, high-speed traders get an early glance at how others in the market are trading. Seems odd, no? After all, if you learn a big secret about a company, trade on that secret, and then make money a month later, it’s considered insider trading and you’d go to jail. When HFT firms get to peek at the buys and sells of others in the market and then make their own trades split seconds later, however, it’s condoned and encouraged by the major stock exchanges. Not only that, HFT machines routinely take advantage of slower traders…or, in other words, us.

Why the loopholes? The exchanges say to “create liquidity,” or to ensure that large investors can buy or sell positions quickly. As you might have guessed, though, the exchanges also earn fees for allowing sneak peeks.

Did a HFT glitch cause the historic crash of last week? Officially, it remains to be seen. Candidly, though, I’ve got a hunch.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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