How to Survive in the Age of High-Frequency Trading

TheStreet.com

By Igor Zhitnitsky and Victor German

NEW YORK (TheStreet) -- The flash crash of 2010, which sent the Dow Jones Industrial Average briefly plunging nearly 1,000 points, brought to public attention the growing influence that algorithmic trading can wield over the market.

In the years following, mini flash crashes of individual stocks became commonplace, even if not always as loud. Beside the occasional flash crash, high-frequency trading, or HFT, is believed to have had a hand in other harrowing market events in recent years. The technical difficulties at Nasdaq on the debut of the Facebook initial public offering, for example, was believed by many to have been at least in part the result of aggressive high-frequency trading. That event caused shares of Apple , Netflix and at least two dozen other stocks to behave erratically for half an hour, culminating in a 17-second shutdown of the entire exchange.

Even the very firms whose sole business is related to trading are not immune to the unpredictability of these algorithms. In March 2012 we saw the BATS Global Markets IPO crash 99.8% in less than 10 seconds, temporarily taking Apple down 9% as collateral damage. Later that year, Knight Capital Group lost $440 million -- four times its net income for the previous year -- in half an hour to a poorly tested trading algorithm.

On the face of it, high speed algorithmic trading is not without casualties. While some proponents contend that the net impact of HFT on the liquidity and efficiency of the market is generally positive notwithstanding exceptional events, we see strong evidence to the contrary.

One stark case study is an event that briefly shook the market on May 23, taking the entire utilities subsector of the S&P 500 down 8% when American Electric Power and NextEra Energy fell 54% and 62%, respectively. The cause of the fall was precisely the sudden lack of liquidity, and the culprits responsible were HFT algorithms. If the value of HFT is to provide liquidity, they failed spectacularly.

So who is happy about the impact of HFT on market conditions over the last few years? According to a 2012 survey by the TABB Group, it isn't the institutional community. When asked to rate their level of confidence in U.S. equity market structure, only 2% of 260 respondents rated their confidence as very high, down from 12% two years earlier, while 26% rated their confidence level as weak, up from 12% in 2010.

Dos and Don'ts

Although we hope regulators will eventually step in and restore some order to the market, betting on the timing and nature of any upcoming changes would be unproductive speculation. In the meantime, it's clear that savvy investors need to adjust to current realities. We researched what works and what doesn't, and here are some of our results:

Do:

1. Go for the kill. Don't expose yourself to the higher level of risk inherent in this market unless the trade promises superior return. When you find it, execute. This means less frequent trading and deeper research.

2. Piggyback on the expertise of professional investors. Doing your own quality research is hard, time consuming and expensive. Use the research reputable hedge fund managers have already done by utilizing services like Stockpickr to pick the brains of professional investors.

3. Minimize use of leverage and increase your time horizon. Being leveraged in a lightning-quick computer-driven environment may result in dramatic losses. Increasing your time horizons is a solid way to mitigate the potential risks that come with increased short-term volatility.

4. Integrate equity indexes into your portfolio. Scholarly research (e.g., Triumph of the Optimists by Dimson, Marsh and Staunton) shows that equity index investing, such as through SPDR S&P 500 ETF , is a solid strategy for a long-term outlook.

Don't:

1. Attempt to trade economic releases or earnings reports. Algorithmic trading platforms feed machine-readable economic and earnings releases into their models to determine the impact of news within milliseconds, leaving a human trader virtually no chance to profit. Competing against a player with this kind of technological edge is unwise. Don't do it.

2. Trade frequently attempting to capture small moves. Exploiting short-term moves is a game dominated by HFT, and with good reason. With millisecond execution times, algos will jump ahead of your orders to capture risk-free opportunity. Don't.

3. Place stop orders. Stop orders are visible to HFT algorithms, which in turn happily prey upon investors who use them. Don't.

Adapting to the new equities landscape isn't the only option. Charlie Munger of Berkshire Hathaway famously referred to abusive HFT algorithms as rats in a granary, and the savvy investor may well want to look into other granaries altogether.

Investment alternatives beyond the more traditional stocks and bonds are growing in popularity and sophistication, offering options for those of us frustrated with the state of affairs in equities. We talked about direct land investment in a previous article, and will discuss other opportunities in upcoming pieces.

At the time of publication the author held no positions in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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