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Four Ways High-Frequency Trading Harms Investors and the Economy

Stocks in this article: FBBATSAAPL

3. Exposes investors to Big Risks

It's common for analysts, even those critical of high-freqency trading, to shrug off its impact on the retail investor. After all, if you trade at most a few times a year and mostly hold stocks for years, why should you worry about a sub-minute flash crash?

While it's true that most retail investors will never directly experience the effects of the flash crashes that high-frequency trading induce, even they are far from immune.

To begin with, many small investors include price stops as part of their risk-mitigation strategy. In the past, you might have placed a stop on your Apple (AAPL) stock 10% below its current price, and felt secure that you had a prudent safeguard in place. Not so after the flash crash of 2012 when, if you had had such a stop in place, you would have been robbed of your 10% within several minutes for no underlying reason at all.

Even if you don't use these kind of long-term stops (you shouldn't), a portion of your wealth (e.g. a retirement savings) is likely in a fund that is interconnected with investment vehicles that may be sensitive to short-term declines.

The fact that high-frequency trading hasn't yet directly caused any events that wiped out a large number of investors' wealth is no reason to pretend that it can't. It would take an unusual set of circumstances, but the risk is there. And the system's built-in obscurity makes that risks all but impossible to quantify, which is perhaps the most worrying part.

4. Passes increased cost of hedging onto consumers.

When a farmer plants corn, he doesn't put his financial future at the mercy of the commodities markets. He insures himself by purchasing corn futures, thereby guaranteeing that he can sell his product at a price point that protects his operation.

Futures contracts are just as prone to price instability induced by high-frequency trading as are equities are, and the increased short-term volatility is priced in. One way or the other, the farmer pays for a portion of the risk and, one way or the other, a portion of that premium is passed onto you at the grocery store.

***

As the public becomes more exposed to what high-frequency does, it seems increasingly likely that outcry will lead to action. Regulators may step in once the realization crystallizes that high-frequency poses systemic risks, but in the meantime, we expect the exchanges themselves to take action first.

If exchanges such as the New York Stock Exchange and Nasdaq are to remain competitive in the face of emerging players such as IEX, they need to regain market participants' trust and rethink their (admittedly lucrative) relationships with high-frequency-trading firms. If they don't, investors may well start voting with their wallets.

At the time of publication, the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

About the authors:
Igor began his career in academia in mathematics and computational neuroscience, and now applies his modeling expertise in the financial and insurance industries.

Victor has a background in math and computer science, and for the past twelve years has been an independent investor and proprietary trader. Victor specializes in fundamental and statistical analysis of event-driven and special situation strategies.
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