Beat high-frequency trading machines by not playing their game

August 29, 2011

The days of you trying to make a buck actively trading in the stock market are over.

Individuals don’t stand a chance anymore because they are largely competing against rational machines often guided by herd-like irrational forces. The robots can rule in the blink of an eye.

I’m not spouting lines from an Isaac Asimov novel, but citing reality. The machines and people who program and profit from them have won — for now.

I knew it was over for human traders when I heard that high-frequency trading firms were hooking up their data lines directly to exchange computers to gain an extra hundredth of a second in execution time.

High-speed programs are designed to move millions of shares in a fraction of a second to take advantage of small movements in securities prices. These algorithms are ideal Wall Street workers. They don’t need health insurance and you don’t have to pay them bonuses to help finance their Lamborghinis or homes in the Hamptons.

There’s no way to beat the machines, unless of course, you have a faster machine, better programs or the ability to predict the future. Your odds are better in Vegas, which never had great odds for a palooka pulling a one-armed bandit.

Who are you trading against when you take on the machines? Any entity from a boutique investment firm with a handful of “quants” — math majors who flocked to Wall Street for the big bucks — to a mega-bank or hedge fund. Some 60 percent of the volume of the New York Stock Exchange is attributed to high-speed trading, maybe more.

Although many market observers blamed machine traders for a flash crash last year, regulators have done little to slow down these speed demons.

Machine traders don’t even need a human analyst to pull the trigger on trades based on the day’s news or price changes. Who watches CNBC any more in these firms? They don’t have to: Machine-readable feeds from all of the news services and exchanges go right into their computers and trading decisions happen without much direct human intervention.

The trading floor is becoming as relevant as the telegraph system.

That’s why will see even more flash crashes and huge price swings called “mini-flash crashes.”

The only perennial truth about the stock market is that it will remain volatile and virtually unpredictable because it’s based on the mass actions of millions of people. It’s like trying to predict the direction of a giant school of dumb fish.

Every day, even more money is chasing potential price swings at the speed of light all over the world. The more traders adopt these systems, the greater the chaos.

There are, of course, various ways of protecting your money from the market madness. Crafting a low-risk, long-term portfolio allocation of stocks, bonds and alternatives for your age, lifestyle and risk profile is one way.

For long-term stock investors, you’ll be better off in exchange-traded funds like the Vanguard High-Dividend Yield fund or the SPDR S&P Dividend fund. Both offer a portfolio of high-dividend paying stocks.

You can also create a high-dividend portfolio of your own, but you’d need to diversify across at least a dozen industries to buffer sector risk.

Dividends generally aren’t impacted by high-speed trading. If a company has sufficient earnings, they cut you a check every quarter. Once you create your portfolio (with individual stocks), you’d enroll in dividend-reinvestment programs to buy new shares on a regular basis on a dollar-cost averaging basis. That would ensure you wouldn’t be buying in at the market peak. The majority of these programs allow you to buy new shares commission-free.

Don’t even try to time the purchase of your stocks, because Washington will do nothing to protect you against huge market swings.

Wall Street is spreading plenty of money around in lobbying efforts to make sure that their trading desks don’t get regulated in any meaningful way. Sated with financial services industry contributions, House Republicans have already spent most of the year trying to kill Dodd-Frank financial reforms, so high-speed trading isn’t even near the top of their agenda.

So my advice couldn’t be more succinct. The best way to beat the machines is pretty simple: Don’t even play them. Game over.


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John, I think you despair of traditional investors “beating” high-frequency trading (HFT) too quickly.

Longer-term investors can exploit behavioral errors and biases in the market. They can buy overly hated stocks cheap, or short overly loved stocks. Classic paper on the subject: soa.pdf

Speaking of biases, your own toward stocks shows through when you think up reasons to buy dividend-paying stocks. HFT can trade those, too. Bond investing provides dividends, too, and municipal bond income is tax-free, an even better tax rate than the soon-to-die 15% dividend tax rate. Individual investors can skip the HFT-tainted equity markets altogether and buy individual bonds, whose over-the-counter market means HFT is almost impossible to implement. A low-cost bond mutual fund or bond ETF would accomplish much of the same strategy.

Posted by BairRightOnBear | Report as abusive

I have nothing against bonds! I just wanted to sound the alarm for stock investors thinking that they had any advantage in the current environment. Yes, holding bonds to maturity is still a good idea.

Posted by johnwasik | Report as abusive

For the past 10 years, I have built relatively strong portfolios primarily incorporating tax free munis. Just about everyone I knew warned me about inflation and the potential damage to bond prices. I reminded them I am a long term investor and that my strategy is to hold bonds to maturity which provides reasonably assured streams of cash. I see nothing on the horizon to alter my views. I hold stocks of course but they are in a minor position so to speak. Re your article: I remember in the late 70’s when computer driven stock trading was under development, how unreal it was going to be in order to determine the real value of any stock or the market generally. I have wondered why not create two exchanges: one for long term investors and the other to satisfy traders?

Posted by Southland | Report as abusive

I would like to know how I can see HFT when looking at the “tape”. What would it “look” like? I am wondering if an endless stream of 100 share lots has anything to do with it. The lot size in a few stocks I was watching, oil stocks, remained as if stuck on 100 share lots.

I also wonder if the price can be manipulated with HFT, that is, can the price be inflated to cause buyers to think there’s a move–in the latest cases, a bottom at last reached–so they will jump in … and be preyed upon.

I appreciate the article, but the typical mainstream advice about diversity and dividends, while generally true isn’t enuf for me, because I keep thinking certain instant drawdowns I have gotten recently were casued by HFT–if not my own bad timing, and own’s timing is doomed up against this game… Any info : TIA !

Posted by Johnnyw | Report as abusive

For practitioners, manager, investors and regulators interested in more information about high-frequency trading, there is a conference coming up, High-Frequency Trading Leaders Forum, in Singapore (this is November 21-23), Hong Kong (December) and Sao Paulo (February 2012). More details:

Posted by Ruixing | Report as abusive

John Wasik is 100% correct when his comments are viewed in terms of day traders. These guys will get kiled when trying to compete with HFT systems. Colocation, Direct Market Feeds, Microsecond Latency, sophisticated algorithms executed in millionths of a second – there’s no way a day trader can be successful except by blind luck. Looking at a screen and applying tried and true Technical Analysis and then deciding to make a trade will be based on old information and the market will have moved – driven by HFT systems.

It is amazing how many firms are trying to sucker newbies in with the promise of get rich schemes through day trading.

In today’s environment, Value Investing for the intermediate and longer term (read trend trading) is the most like avenue to success. Technical Analysis can be applied successfully – just don’t think that as a neophyte day trader you can use these techniques to beat the system.

Posted by alejandrorey | Report as abusive