High Frequency Trading should not be permitted, let’s favor the public for a change

Readers may recall about ten years ago that several traders were caught alerting their accomplices of stock buy orders coming in on a very “major stock exchange.” As the orders came in, the traders would alert their accomplices who would then buy the shares first for themselves and then for the broker’s clients. The very customer who had originated the order would pay a higher price. Not right nor fair.

It would take a few extra seconds for the front runner to put his order in front of the legitimate customer, buy the stock and quickly offer that same stock for sale. That particular stock exchange which is quite vigilant, caught on to the pattern and the perpetrators were later arrested. Sadly, one served time in prison. Again, what were they doing? Simply stated, they were quickly putting their own orders in front of the customers’ orders and when they completed the purchase of their own order, they would sell the shares generally at a slightly higher price to the customer or another buyer at a slightly higher price. Was the difference in prices paid much? Probably not, it depends on many factors but rest assured the buying customer in the majority of cases paid more than he or she or an institution should have.

It is more complex and much more rapid today than I can describe here but the theory is the same. A HFT computer determines what stock(s) is being bought as the true original buyer’s(s)order is entered and through a more rapid high frequency order system, the HFT computer’s buys that same stock and the order beats the legitimate investor’s order to the actual execution of the transaction. Bottom line is HFT firm’s order is in front of the true legitimate investor who initiated the order. The HFT trader can turn around and sell the position right back to the true legitimate investor-within two to three seconds. The entire operation takes seconds! It is permitted, but it is not fair. And keep in mind that it is estimated that High Frequency trading is now between 50% to 60% of the volume on the New York Stock Exchange.

Keep this in mind, here is what can happen as well.
Just suppose that an investment firm decides to purchase a large amount of a stock that their research finds to be undervalued and offering exceptional capital gains potential. If the stock is not followed on a research basis and is not liquid, just one mere order can alert the market that interest in that stock has developed. Some of the offerings of that particular stock that would be for sale can disappear and be re-offered at higher prices. When that occurs, the price of any stock can move up quite quickly.

For example, let’s suppose that the investment firm wants to accumulate 500,000 shares of XYZ stock. If a high frequency trader is “in front” of the order, the firm may end up paying an additional 1/8 per share on average over the course of the purchases. As you know, 1/8 is an additional .125 cents per share so do the math. Over the life of the order being filled which could be several weeks, it could cost the investment firm an additional $6250. An old rule when accumulating a stock is “keep your mouth shut” and it still stands. HFT doesn’t help.

Protect the investing public: Bring back the “uptick rule” for shorting stock
Finally, the SEC should consider the fact that there is no required “uptick” when shorting a stock. This permits short sellers to sell short with no restrictions and “pile in” to the market and literally pound stock(s) and the market as well. When this market enters a bear phase, expect the High Frequency Traders to engage in enormous short selling. With no uptick, it could create chaos. I cannot understand why the SEC ever repealed the “uptick rule.” There is an ugly rumor that it was because trading desks wanted it repealed so they could short and profit with impunity. But of course that is just another ugly rumor.

What is the purpose for the stock market?
A key question is whether the stock market is there for true investors or for high frequency traders. We had always thought that major purposes of a stock market are to offer liquid markets for buying and selling corporation’s shares, to help create economic development from the traded companies and offer the possibility of profits to the investing public. Somehow something got lost along the way, today the market seems to be there primarily for the HFT traders. The bottom line is the rules have been changed to benefit the High Frequency Traders at the expense of the investing public.

A final but profound note
Bill Bresnan is a very successful business radio commentator and financial author who spent his early career after graduating from Columbia University as a clerk on the floor of the New York Stock Exchange. He saw it all and knows the markets well. His opinion of High Frequency Trading is “that it is so unfair to the investing public.” Like many Americans and Canadians, he believes that investing in common stocks offers exceptional opportunities but the average investor is put at the end of the line today. Amen Bill.