Why You Shouldn't Worry About High-Frequency Trading

Market Frenzy Analysis
Richard Drew/APThe day after the 2010 flash crash.
There are plenty of things in life you need to worry about, but high-frequency trading isn't one.

When I shared this thought with my colleague Nick, his response was "As in, don't worry about the HFT guys allegedly skimming billions off the market by arbitraging microseconds?"

"That's right," I said.

Why High-Frequency Trading Is Decreasing

Some brokerage firms use super-expensive equipment to get access to more information and get that data faster -- slivers of a second faster. The edge allows them to trade in and out stocks in a flash and make a profit of maybe a thousandth of a cent per share. But since they do this millions of times a minute, these fractions add up. They also use their technological advances to flood the market with bogus trades in an effort to confuse the market and confound competitors. It's a billion-dollar industry that some people are up in arms about. Let me tell you why I'm not one of them:
  • The industry is shrinking. According to the New York Times, HFT firms are going to bring in $1.25 billion this year. That's serious money, but a 35 percent drop since last year and a 75 percent slide since 2009. According to the Times, many firms are closing or cutting staff.
  • There is less opportunity. Profits are dropping. Overall trading volume has declined, and that means fewer prospects for high-frequency traders to work their evil.
  • It's becoming more expensive to maintain the technological edge. To shave off the first 30 milliseconds was easy. The next 30 milliseconds will be very costly.
  • As word got out about HFT six or seven years ago, more players jumped into the game. That increased downward pressure on profits and also introduced mutual funds to this technique. Since at least some mutual funds are HFT traders, investors themselves are participating in the profits, too.
  • Increased scrutiny from regulators around the globe means players are less enthusiastic about getting into or staying in the game.
How HFT Helps and Hurts Small Investors

On the positive side, studies suggest HFT helps investors by creating liquidity and reducing the cost to trade buy keeping spreads thin.

%VIRTUAL-article-sponsoredlinks%On the negative was the May 6, 2010 "flash crash," in which the marketed cratered 9 percent. The crash happened as a direct result of one transaction -- a $4.1 billion sale of futures contracts.

But I'm not even worried about that sort of event recurring. First, odds are high that measures soon will be put in place to curb this kind of wackiness. The Chicago Federal Reserve suggested several controls.

And the market itself is at work. The market did crash 1,010 points on that terrible day in 2010. But it regained every cent within minutes. Why? Because the same algorithms that flashed "sell" turned around and flashed "buy" when they recognized the prices were artificially low. These flash crashes are problems, but they self-correct. Long-term investors won't be impacted by HFT.

7 Tax Tips for Investors
See Gallery
Why You Shouldn't Worry About High-Frequency Trading
The 1099 forms you received from brokerages and other financial institutions might not be the last ones they send. It's common for them to issue corrected versions a little later. Consider getting your tax return ready to go, then waiting until close to April 15 before submitting it. That way, you can incorporate any last-minute changes and avoid having to file an amended return.
Pay attention to when you sell any holding, because the capital gains tax rates differ for long-term and short-term holdings. Short-term capital gains are taxed at your ordinary income tax rate, which could top 30 percent. Long-term gains (those held for more than a year) get preferential rates, which are zero percent for those in low-income brackets and 15 percent for most of us.
If you own underwater stocks, consider selling them for a loss. You can use those losses to offset gains from other sales, reducing your taxes owed. You can always buy back the asset later, if you still believe in it -- just be sure to wait for 31 days to pass, to observe the "wash sale rule."
If you're planning to sell one or more holdings that will give you a really big gain, submit an amended W-4 form to increase your withholding, or send the IRS an estimated tax payment. Underpaying your taxes significantly during the year can lead to a penalty at tax time. You may be protected by a "safe harbor" provision, though, which can save you from having to jump through those hoops.
If you're planning to buy shares of a mutual fund, determine when it will distribute its dividends. Many funds do so near the end of the year, and when that happens, the fund's share price will drop by the amount of the distribution -- which is taxable to shareholders. It's better to just wait until after that payout to buy in.
Mutual funds with high turnover ratios (reflecting a lot of buying and selling in a fund) have expenses for these trades. It's worth favoring funds with low turnover ratios, especially index funds and index-tracking ETFs, which simply hold onto the mix of securities in a given index, without a lot of trading activity. (Index funds generally outperform their higher-turnover counterparts, too.)
Boost the power of your Individual Retirement Accounts by making your annual contributions early in the year, giving the funds more time to grow. Over decades, it can make a significant difference.

[Correction: A previous version of this article inaccurately described the opinions of Eric Hunsader, owner of market technology and data firm Nanex, on HFT, based on an article in Forbes. DailyFinance regrets the error.]
Read Full Story