High-Frequency Trading

High-Frequency Trading (also known as HFT) is a type of algorithmic trading that uses powerful computers, complex mathematical models, and lightning-fast data connections to buy and sell securities in fractions of a second. Imagine a trading world that operates not in minutes or seconds, but in microseconds (millionths of a second). This is the domain of HFT. These firms don't care about a company's management, its products, or its long-term prospects. Their goal is to profit from tiny, fleeting inconsistencies in stock prices, executing millions of trades a day to skim minuscule profits that add up to enormous sums. To gain a speed advantage, HFT firms often engage in co-location, placing their computer servers in the same physical data center as an exchange's servers. This shaves critical microseconds off the time it takes to send and receive data, giving them a crucial edge over everyone else. For a value investor, HFT can seem like a completely alien, and perhaps unsettling, part of the financial ecosystem.

At its core, HFT is an arms race for speed. The firm with the fastest connection and the smartest algorithm wins. While the strategies are incredibly complex, they generally fall into a few key categories.

This is the most common and least controversial HFT strategy. HFT firms provide liquidity to the market by placing both buy (bid) and sell (ask) orders for a particular stock at the same time. They profit from the tiny difference between these prices, known as the bid-ask spread. By constantly quoting prices, they act like digital market makers, making it easier for other investors to buy or sell.

This is the classic “buy low, sell high” strategy, but on steroids. HFT algorithms scan multiple exchanges simultaneously, looking for minuscule price differences for the same stock. For example, if Apple stock is trading for $175.00 on the New York Stock Exchange and $175.01 on the Nasdaq, an HFT algorithm will instantly buy on the NYSE and sell on the Nasdaq, pocketing the one-cent difference. This happens so fast that the opportunity vanishes almost as soon as it appears. This practice of exploiting price discrepancies across different markets is known as arbitrage.

This is where HFT gets its notorious reputation. Some advanced strategies are designed to outsmart and exploit other traders, including other algorithms.

• Momentum Ignition: An HFT firm may place and quickly cancel a series of orders to create the illusion of buying interest, tricking other algorithms into buying the stock and pushing the price up. The HFT firm then sells its own position into that artificial demand.
• Spoofing and Layering: These are illegal practices where traders place orders they have no intention of executing, purely to manipulate prices. Spoofing involves placing a large, visible order to trick the market, while layering involves placing multiple fake orders at different price points to create a false sense of supply or demand.

The role of HFT in modern markets is fiercely debated. Is it a force for good, or a destabilizing parasite?

• Increased Liquidity: Supporters argue that HFTs are the market's primary liquidity providers. This constant flow of buy and sell orders can narrow the bid-ask spread, theoretically making it cheaper for everyone to trade.
• Better Price Discovery: By rapidly pouncing on any mispricings through arbitrage, HFTs help ensure that an asset's price is consistent and accurate across all markets. This process, known as price discovery, is a hallmark of an efficient market.

• Systemic Risk: The sheer speed and interconnectedness of HFT can create extreme volatility. A single faulty algorithm could trigger a chain reaction of automated selling, leading to a flash crash, like the infamous event on May 6, 2010, where the Dow Jones Industrial Average plunged nearly 1,000 points in minutes before recovering.
• An Unfair Playing Field: Critics argue that HFT creates a two-tiered market: one for the ultra-fast and one for everyone else. Ordinary investors and even slower institutional investors can't compete, effectively paying a hidden “tax” to HFT firms on their trades.
• Focus on Noise, Not Value: HFT adds nothing to the capital allocation process. It doesn't fund new businesses or help companies grow. It is a zero-sum game that extracts value from the market's short-term “noise” rather than creating long-term economic value.

As an investor focused on the principles of value investing, you might be wondering how to navigate a market seemingly dominated by machines. The answer is simple: don't play their game. Your advantage is not speed; it's patience and perspective. An HFT algorithm's “holding period” is a few seconds, at most. Your holding period should be years, if not decades. The daily, minute-by-minute, or microsecond-by-microsecond price jitters caused by HFT are completely irrelevant to your goal of owning a wonderful business at a fair price. Your focus should be on a company's long-term intrinsic value, not the fleeting blips on a screen. Here are two simple ways to protect yourself from the negative aspects of HFT:

1. Always Use Limit Orders: When you buy or sell a stock, use a limit order instead of a market order. A market order executes immediately at the best available price, which can be surprisingly bad during a moment of HFT-induced volatility. A limit order lets you specify the maximum price you're willing to pay or the minimum price you're willing to accept, giving you control and protecting you from sudden price swings.
2. Think Like an Owner, Not a Trader: Remember that you are buying a piece of a business, not just a ticker symbol. HFTs trade symbols; you invest in businesses. As long as you maintain that long-term mindset, HFT is little more than a sideshow. Let the algorithms fight over pennies while you focus on owning great companies that will compound your wealth for years to come.