High Frequency Trading

High-frequency trading is when financial institutions, traders or brokers use sophisticated computer algorithms and high speed data networks to make lightning fast trades. The objective is to make a very small (sometimes only a penny or two) on a large number of trades because the algorithm spots trends before humans and can buy or sell faster.

Anyone reading business magazines is familiar with the concept and accepts it as part of the stock trading process. My question is what value does the stock market add to our society?

Stocks are a form of ownership in a company and business sell their stock to raise capital for buying real estate to house their operations, to buy equipment to improve productivity or maybe just so the owners can recover some of the money they already spent to create the company.

That’s the theory but very little of the stocks being traded today were sold by the company itself, most being re-sold by people who originally bought it when the company first sold it. Perhaps it has been bought and sold many times since the company it represents first sold it to raise capital.

So, how does stock in the secondary market benefit that original company or society in general? If I invest in a company and get stock shares instead of just an IOU then I can sell those shares to someone else when I need or want my cash back. The stock market acts just like a supermarket by putting all the different stocks in one place where buyers can find the ones they want.

That’s the value to the investor but what is the value to society? If I invest in a company and have to wait for them to buy back those stocks or for them to pay dividends I might have my money tied up for a lot longer than I might want and I might not invest at all.

The ability to cash out by selling on the secondary market makes the investment more attractive and helps companies that need the cash to create and make product that people want easier.

OK, I get that. But what value do these “high frequency traders” add?

The honest answer is very little since they are buying a stock for $10.03 and selling a minute later at $10.10 they have not added any value to the process. Yes the seller got a buyer at 10:01 AM. Without that HFT in the process they would have still sold the stock at 10:02 but for $0.07 cents per share more.

Most sellers aren’t selling huge numbers of shares so the seven cents is unimportant but the HFT is dealing thousands of shares and if they only touch 1,000 shares that means they pick up a $70 profit. Now seventy bucks is nothing but suppose they do that with 100,000 in 1 minute ($7,000) and repeat that every minute with yet another stock on and on?

Remember that this is a computer program that never get’s tired or takes a break. They really aren’t adding any value to the process but they are adding cost to the market and driving up the price by that fraction.

When the government imposes a tax we expect that we are paying for some service that adds value to our lives – sometimes it actually works out that way. Same for fees that airlines or banks charge – sometimes we actually get some additional service for that money. The fraction that HFT adds to the cost of stocks acts as a tax or fee, increasing costs but returns no addition value to the seller, to the buyer or to society at large.