NOTE: This was from my old A&L Enterprises blog – but I thought it was interesting…
I recently read Michael Lewis’s recent book: Flash Boys – A Wall Street Revolt. This was an interesting read – which I did under Amazon’s new “Unlimited” program. I first heard about this book (and it’s interesting topic) on a CBS News broadcast – where they interviewed the author. The focus of the book was on the effect of “high speed traders” on the stock market – on how they are affecting the market as a whole.
The basic premise of the book is that there are certain high-speed traders (HFT) that have a market advantage due to their speed and special relationships. This market advantage enables them to be able to predict trades/future prices and make quick deals to take advantage of this. In the end they make money on the deal – money that essentially comes out of the investor’s pocket.
For example, you place a trade to buy 1,000 shares of Microsoft stock with your broker. At present there aren’t actively 1,000 shares available from any one seller on a single exchange. Therefore your broker puts in a number of trades with different exchanges to purchase those shares. What often happens is this:
- Your trade arrives at exchange #1 and a buy of 100 shares is executed.
- A high speed trader on that exchange detects this activity and quickly (faster than you) buys the same shares at another exchange – therefore driving up the price.
- When your trade arrives at the next exchange the price has already gone up – as that HFT is going to sell it to you at a now higher price. Therefore your trade will either not be executed (as the price is higher than you allowed) or you will end up purchasing at a higher price.
Basically the HFT has an information advantage over you – in that they know (or actually cause) a change in the price of a share that you don’t have access to. This is due to their higher speed links, special relationships with the exchanges, special relationships with investment banks, etc. In a way the price for a commodity you see is now incomplete – as the market has changed fundamentally.
Morals aside (as this could be considered front-running) – the key point here is the <em>information advantage</em>. The individual investor knows less than their broker (although today the investor can certainly know a lot more). That individual broker knows less than the investment bank they may route the trade through – as the actual execution of the trade isn’t very transparent. The king of information in this case is that HFT – the high speed trader – as they gather a lot of information and react very quickly to it.
In today’s economy information is now so key to execution and advantage. The lack of information can be crippling – as in the case of the investor not being able to know how their trade is being executed (they essentially don’t know the true price). Frankly they don’t even know in most cases this is going on – as again that information isn’t readily available. On the other hand – the information that the HFT has enables to produce large profits on a regular basis (without much risk).