April 4, 2014
The topic of high frequency trading has been in many discussions recently with the release of Michael Lewis’ new book “Flash Boys”. The book makes strong claims, including that the stock market is “rigged”, based on the methodologies of high frequency traders. We would like to briefly discuss how high frequency trading works, and then how it does or does not affect Miller Russell Associates and its clients.
Before digging into the details of trading, it’s important to distinguish between two market participants: price takers, who take the price others are giving them; and liquidity providers, who dictate the price at which they are willing to buy or sell a security. For example, let’s say you wanted to buy a share of Microsoft (ticker symbol MSFT). If you looked at the market at this moment, you would see a bid price of $40.88 per share and an offer price of $40.89 per share.
If you are a buyer of Microsoft stock, you have two choices in placing your trade. You can place your order at the bid price of $40.88 and wait for someone to sell it to you at that price. In that instance you are a liquidity provider; if someone wants to sell Microsoft you are a buyer at that price. Your other choice is to “cross the spread” and place your order at the offer price of $40.89. In that case you are a price taker; you want to buy Microsoft and you will take the price the seller, or the market, is giving you.
The challenges with high frequency trading only exist for price takers, and then only for those who have an urgency to execute their trade. While on occasion this can be the retail investor, in most cases it affects large bulk traders who have an urgency to execute a specific stock at a specific time. For these traders, they may want to buy 100,000 shares of Microsoft and see it offered at $40.89. Those 100,000 shares at $40.89, however, are typically a number of sellers offering smaller lots across multiple exchanges. When they go to execute their trade at $40.89, 20,000 may execute immediately at one exchange, and then to them it appears that all of a sudden the price has changed on all the other exchanges and they can’t execute the other 80,000 at that price.
In simple terms, what has occurred is that high frequency traders were able to see the first order execute at $40.89 and cancelled their offers on other exchanges at $40.89, and instead raised the price to $40.90 or $40.91. If the bulk trader needs to buy 100,000, he now needs to pay a penny or two more to execute the other 80,000. To him, this doesn’t seem right because seconds ago the market told him he could have executed the entire order at $40.89.
Lewis is arguing that this means the market is rigged and that quoted prices aren’t always valid. That is a difficult argument to make; however, because this scenario happens all the time in markets, even beyond the stock market. It’s simply a response to recognizing demand in the market place. It happens all the time at Christmas with the hottest toys on the market. For instance, last year one of the most popular toys was called a Zoomer. It was a robot dog that you could program to do tricks. If you were looking for a Zoomer two weeks before Christmas, you couldn’t find one in a retail store. Your only option was to go to a public market, like eBay.
Let’s assume you have two kids and you want to buy two Zoomers. You see there are two sellers on ebay, each selling a Zoomer at a “buy it now” price of $80. You purchase the Zoomer from seller A for $80. However seller B refreshes his screen and notices that a Zoomer just sold for $80. So he changes his “buy it now” price to $85, recognizing that there is demand in the market. You may be unhappy that to buy the second Zoomer you now have to pay $5 more, but the seller has done nothing wrong. He is simply responding to all available information. Clearly the speed at which he accesses this information matters. Had he not seen the previously executed sale, he would have sold his Zoomer to you for $80. This is where high-frequency traders have an advantage. The sooner they can get information on trades, the sooner they can react to the market.
However, the buyers of Zoomers, Microsoft, or any stock always have the option of not buying at the higher price! This is why it matters whether you’re a price taker or a liquidity provider and whether you have urgency or can be a patient investor. To a liquidity provider, high frequency trading is irrelevant. They have placed their orders at a specific price and have no urgency to have it executed at any other price. In fact, most market participants other than price takers would argue that high frequency trading and computerized trading have probably helped markets more than they have harmed them. Their ability to transmit and act on information quickly has increased competition and has led to more liquidity in the market, cheaper transaction costs (both in trading costs and the spread between the bid and offer), and a more transparent market (as opposed to a floor specialist at the New York Stock Exchange).
How does high frequency trading affect Miller Russell Associates? First of all, as advisors, we do not trade in individual stocks. We primarily use liquid mutual funds which execute after the close of the market at the net asset value of the underlying stocks in the portfolio. If there was any impact to our clients, it would be at the underlying manager level.
Fortunately, the bulk of our equity managers are factor based and are not attempting to actively pick stocks in a way that would require urgent execution. As a result, they are liquidity providers the majority of the time. They are more interested in specific exposures to risk premiums in the marketplace like size, value, variance, or fundamental metrics. They can access these exposures in various ways, with no preference for specific stocks at specific times.
We at Miller Russell Associates believe that markets work and that high frequency trading and computerized markets have provided benefits along with their challenges. Furthermore, regulation may benefit some investors, but if too strict, it could do more harm than good to the market as a whole. We think it’s important for investors to remember that they always have a choice when investing in the stock market. As Benjamin Graham would say, Mr. Market will turn up every day at the stock holder’s door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn’t mind this, and will be back the following day to quote another price.