Does flash trading cheat the average investor?

The Securities and Exchange Commission (SEC) is considering a rule to ban flash trading, in which computers fed with order information trade stocks moments before the exchange executes those orders. Conceptually, it sounds like an open and shut case of insider trading to me.

The SEC's thoughts on flash trading are pushing some to ban the practice preemptively. Two exchanges -- NASDAQ and Bats Global Markets -- where flash trading used to occur have ended the practice. But flash trading still takes place at Direct Edge Holdings LLC.

And in case you thought flash trading was a minor matter, consider that it accounts for most of the trading volume in the U.S. At least that's if you believe the estimates of Raymond James & Associates analyst Patrick O'Shaughnessy, who told Bloomberg: "High-frequency trading may account for 70 percent of share volume in the U.S."

In 2008 flash traders made $21 billion in profits -- that's a pretty high price for the rest of us to pay for their exploitation of inside information.

Flash trading gives its practitioners an unfair advantage over other market players. It gives material, market-moving information to those few who can afford to build and operate the computers needed to capture and trade on the order information less than a second before a trade is executed.

How so? A flash trader who knows, say, that there are orders to sell 20 million shares of Apple (AAPL) at the market opening -- this figure is about 100 times more than the average trading volume of 200,000 shares -- could short shares of Apple right before that order was executed and make a tidy profit.

Not having access to that information, all the other market players would lose money because of the flash trader who would drive down Apple's stock below where it would be if it did not use that material, market-moving information.

By the way, if the SEC starts to crack down on this, it should definitely start to look at the trading of big hedge funds. As I posted, Renaissance Technologies, headed by James Simons who regularly pulls in billions of dollars a year, is alleged to have used a similar kind of process -- buying limit order books which contain details of the price at which investors wish to sell their holdings to limit their losses (or gains) -- to earn high returns.

This is a form of front-running that sounds similar conceptually to flash trading. As I wrote earlier, a firm could look at such data and identify a large sell order for a stock that was trading at $15.05 -- but the sell order was for $15 a share. The fund could sell the stock short at $15.01 and then cover its position when the sell order was executed at $15 -- making a penny a share in profit

If the SEC starts to crack down on such insider-like trading, the market would probably be much fairer. But given how badly investors have been burned over the last decade, it is unclear whether the average investor would take up much of the slack.

Peter Cohan is amanagement consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

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