Defeating HFT

Sometime around 2006 to 2007, high frequency traders began to be a problem for large traders. Michael Lewis told the story in his 2014 book Flash Boys, which highlights the experiences of Brad Katsuyama in first trying to make money for his employer, RBC Securities, in electronic trading, and later as a founder of Investor's Exchange (IEX). Though the story isn't new, it's worth exploring because HFT is still present and it is a feature of the investing landscape.

This passage from Flash Boys shows how pernicious the HFT traders were:

If that was the case, he asked them, why did the markets in any given stock dry up only when he was trying to trade in it? To make his point, he asked the developers to stand behind him and watch while he traded. "I'd say, 'Watch closely. I am about to buy one hundred thousand shares of Amgen. I am willing to pay $48 a share. There are currently 100,000 shares of Amgen being offered at $48 a share--10,000 on BATS, 35,000 on the New York Stock Exchange, 30,000 on NASDAQ, and 25,000 on Direct Edge.' You could see it all on the screens. We'd all sit there and stare at the screen and I'd have my finger over the Enter button. I'd count out loud to five...

"'One...

"'Two.... See, nothing's happened.

"'Three.... Offers are still there at 48...

"'Four.... Still no movement.

"'Five.' Then I'd hit the Enter button and --boom!--all hell would break loose. The offerings would all disappear, and the stock would pop higher."

At which point he turned to the guys standing behind him and said, "You see, I'm the event. I am the news."

To that, the developers had no response. ...  "Then they'd disappear and never come back."

In other words, there was nothing wrong with the software. It was behaving exactly how the market-making HFT crowd wanted it to function, which means that it allowed them to perform time arbitrage on large orders, front-running on nearly every trade. If you want to buy, they first mark the stock up. If you want to sell, they first mark the stock down. Was this new behavior, enabled by the avalanche of new internet technologies that had been brought to the market in the last 15 years?

Later in the book, Lewis describes how John Schwall, who worked for Banc of America when Merrill Lynch was fraudulently forced onto Bank of America's books by the U.S. Government, costing BAC shareholders $100 billion, began to trace the history of Wall Street regulations by first digging into the internet on his iPad, and then searching in the Staten Island branch of the New York Public Library:

Several days later he'd worked his way back to the late 1800s. The entire history of Wall Street was the story of scandals, it now seemed to him, linked together tail to trunk like circus elephants. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice. "No matter what the regulators did, some other intermediary found a way to react, so there would be another form of front-running," he said. ... He'd learned several important things, he told his colleagues. First, there was nothing new about the behavior they were at war with: The U.S. financial markets had always been either corrupt or about to be corrupted. 

What does one do with this? Avoid equities, raise your fist and voice to the sky, and yell defiance? 

It's not quite that bad, because first you have to realize that most markets, including product markets, real estate, and even government services, are going to have at least some of this problem. Think about buying a car. You also have a lot more agency than Lewis' prose implies. First of all, we're talking about 0.01% or perhaps 0.1%, which is far less than the spread in the days of fractional stock prices. Second, if you hold your stock for five years, your prospective gain is something like 50% to 100%, which dwarfs the loss to the HFT. Third, this is only a problem if you are trading too much or trying to optimize all trading costs out of your investing. 

A short piece of fiction: Alien lands on earth. Knowing nothing, the alien asks, where can I invest? Broker sells him a 6% investment. If the alien had known better (he did no research at all), he could have had the same investment for a 12% gain. Was the alien ripped off? Perhaps not. After all, he could have gotten nothing. At least he got half.

So the lesson here is that agents acting on your behalf will want something. Without those agents acting, we wouldn't have access to equities at all.

So now that I've almost excused the thieves from their deeds, let's learn how to rip them off.

How to Defeat HFT

It's quite simple, but it requires discipline. First, notice that HFTs make money when you trade. If you don't trade, they make nothing. If you own the stock, they make nothing. So the best way to defeat the HFTs is buying and holding for the long term. If you hold your positions for five, ten, or twenty years, the HFTs make no money all for a very long time. And since they didn't get paid much to start with, when you bought your stock, they never really got much money for their trouble. 

Second, with zero commissions, you can buy even small lots of one to ten shares, which make practically nothing for the HFT, but which gradually build your portfolio. In the 1970s brokerage fees on any trade might have been $100 or $200. In the 1990s they dropped to $30 to $100. Before Robinhood the discount brokers were still charging $5 to $20 per trade. Zero commissions make up for a lot of other friction, including losses to HFTs. The lower obstacles to getting started with equity investing is a huge bonus. Just two years ago, if you were concerned about the "load" you were paying in the form of commission, your minimum sensible investment was perhaps $500 to $1000. In the post Robinhood era, you could place trades for $50 of stock, and there is practically no friction at all.

The ultimate trading pattern for the anti-HFT trader is therefore buy-and-never-sell. In practice, this might mean five to ten years between opening and closing a position. From the perspective of the HFT, this is cheating. They don't make enough from a single trade to cover their costs. It is when you trade repeatedly that they make up the overhead of maintaining the fiber optic lines, computers, and custom software on the many small slices they take from those many trades.

Let's suppose that an HFT is manipulative, and they temporarily open up a lower price for a minute or two, to draw interest in. If you place a buy order during their maneuver, they may think of that as an investment in which your subsequent sell, additional buy, and so on recoup the cost of the temporary dip in price. Your role, as they think of it, is to then trade several times. If instead you hold the stock for ten years, in effect you've taken the ball and gone home, refusing to play the game further. In this scenario you did your homework, bought the stock at a price you figured was less than the company was worth, especially over the long term, and held it for ten years, obtaining a successful outcome.

This is a strong move, can be done unilaterally without any cooperation from your broker, exchange, or counter parties, and you need provide no warning to anyone, including the SEC or your Congressman. You buy and go home, and you don't need to think about it again.

Each day that you allow to pass without further action is a day of grinding down the HFT. They may make money from others, but in absence of a trade from you, they are losing a little bit each day. Again, you need do nothing to win daily. The fluctuating stock price may not reflect it, as it will go down as well as up, but the average daily movement, provided that you chose a profitable and growing company, will be up. You win.