60 Minutes recently reported on High-Frequency Trading (HFT) and its impact on the every day investor. Due to the nature of this style of trading, investors are concerned that High-Frequency Traders have a significant advantage over the “little guys.”

Is High-Frequency Trading Something to Worry About?

Cassaday & Co. has raised concerns about HFT for years as it pertains to market volatility. HFT accelerates whatever trend is in place and can unnaturally increase volatility. Volatility causes a variety of problems for market participants, most notably increasing the emotional energy level and raising the probability of behavioral mistakes like market timing. However, on a net basis, HFT is beneficial to the marketplace and ordinary investors.

HFT exploits micro differences in stock prices between markets as well as the differences between index mutual and exchange-traded funds (ETFs) and the underlying index components. When micro differences in the market price of the same stock in different places exist, buying at the lower price and selling at the higher price times millions of shares can mean large profits for traders able to exploit these differences in a few milliseconds. HFT can regularly account for more than 50% of the trading volume on any given day.

The Benefits of High-Frequency Trading

HFT is the primary reason why index ETFs work. For ETFs to accurately reflect the value of the underlying index, there must be parity between the index’s price and the ETF’s price. Any difference – even a very small difference – is immediately exploited by the HFTs, thereby creating and maintaining parity with the index. Parity means that ETFs accurately reflect the index’s price throughout the trading day and that is a positive thing.

Another benefit of HFT is that the difference between the bid and ask prices of a given stock, known as the “spread”, has tightened remarkably. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. The difference between these two prices is an implied cost of investing since the spread must be made up before a profit is realized.

According to Forbes Magazine, “The vastly higher amount of trading that is being done as a result of the technique has meant that the spreads, the differences between the ask and bid prices, have collapsed. They’ve actually gone down from 0.2% in the mid-1990s to 0.002%”. This means that Wall Street’s profits have gone down with the savings going to average investors.

How Does This Affect You?

Since Cassaday & Company, Inc., primarily invests through mutual funds and ETFs, our clients are not affected by the same issues that can trouble buyers of individual stocks. The companies that administer our clients’ money are large institutions with sophisticated and experienced trading operations that skillfully execute buy and sell transactions consistent with your best interests. Aside from the volatility mentioned above, HFT does not affect our system of investment management.

Although not perfect, and probably in need of some fine-tuning, HFT is generally a positive for investors. As usual, our greatest risk as investors is political. Regulatory or legislative changes conceived in an environment where panic is prevalent are usually not a recipe for good rulemaking.

As always, should you have any questions on this topic, please contact us.

To view the report from 60 Minutes, click here.