There’s an underground investment world lurking in the bowels of Wall Street’s biggest firms. It’s a world that the vast majority of investors have never heard of -- and its participants could be pillaging your investment profits on a daily basis. That said, there’s a way out for smart investors†I’ll tell you what it is in a minute. High-Frequency Trading (HFT) is a not-so-new trend that’s been causing a frenzy among the minority of investors who have heard about it. With HFT, firms use sophisticated computer systems to analyze markets and execute trades at ultra-high speeds -- sometimes in a matter of nanoseconds. These systems make money for their firms by making a very small profit on a very high volume of stocks. That adds up to a lot of money†some estimate that firms like Goldman Sachs, one of the leading firms in HFT, make up to a quarter of their profits from high-frequency trading. And all of that activity has a big effect on individual investors. It’s estimated that in 2009 HFT accounts for approximately 50% of transactions on exchanges like the NYSE and NASDAQ. All of that volume has monumentally increased the volatility of stocks according to a recent whitepaper on toxic equity order flow by Themis Trading. â€Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year. Recent spreads on S&P 500 stocks have doubled compared to earlier in the year,†the paper explains. That’s a frightening statistic when you consider the fact that much of the downside in that 4% price swing is being absorbed by investors who aren’t sophisticated enough to counter the big firms. But that’s not the whole story†While most investors are familiar with major stock markets like the NYSE or NASDAQ, did you know that there are a number of other exchanges out there, like the Boston Stock Exchange, the International Securities Exchange, or the BATS Exchange? That’s not to mention the Electronic Communications Networks (ECNs) and dark pools that act like under-the-radar clearinghouses for big firms who want to keep their trades hidden. There’s nothing nefarious about these alternative exchanges or firms’ desire to keep their trades away from predatory traders †but when you consider the fact that these off-exchange trading options account for nearly 75% of the volume of NYSE stocks, it’s disconcerting to think about just how much impact these underground trading options have on the prices of the stocks that the vast majority of regular people invest in. The Unfair Advantages of HFT Access to underground exchanges isn’t the only unfair advantage that high-frequency traders have. They also have faster execution speeds thanks to a growing trend known as co-location. With co-location, firms get to rent server space right next to the servers that process trades for the exchanges themselves. And it’s becoming big business for the exchanges, which are hungry for more revenues in this era of increased competition. The New York Stock Exchange is currently in the process of building two cutting-edge trading hubs †one in suburban New Jersey and another just outside of London †at a price tag of $500 million. That closeness to the exchange’s servers only gives HFTs an edge of a couple nanoseconds †but for firms who measure their trades in microseconds or less, that’s a hugely valuable advantage. Up to now, the SEC hasn’t stepped in to regulate the practice of co-location. Another unfair advantage of high-frequency traders is the way they make profits. While there are a number of different kinds of HFTs (including liquidity rebate traders, automated market makers, program traders, and predatory algorithm traders), each with their own profit strategy, the method of choice often either involves making marginally unprofitable trades in order to collect a larger â€rebate†from the exchange or legally tricking other large players into buying recently-bought shares at a higher-price. While many proponents of HFT argue that firms who trade at these volumes add a lot of liquidity to the markets, the fact remains that the liquidity they add isn’t healthy †it’s often mispriced because of market information asymmetries that big firms (and smaller, more aggressive firms) can take advantage of. The Secret to Avoiding HFTs Pitfalls If you’re nervous about the impact high-frequency trading will have on your portfolio, don’t be. There are a couple of things you can do to avoid getting bitten by the big program traders. First, do your homework. Using solid fundamental analysis gives you the advantage of qualitative, not just quantitative, research. And know that on an individual level, the effects of HFTs on your trades are incredibly small. As long as your share price is justified by a strong investment case, you have nothing to worry about. Another way to avoid HFT manipulation is to take a look at small-caps. High-frequency traders rely on heavily traded blue chips to make their marginal gains. When you invest in smaller stocks that stay under the radar of program traders, you can discount any effects they have on your investments. While high-frequency trading continues to get the financial media’s attention, it’s likely we’ll see some more much-needed regulation in the field. Until then, following these tips will keep you one step ahead of the fastest traders on â€The Street.†Even with the concerns of HFT taken care of, order execution is another stumbling block for many investors†You could be losing serious money every time you buy or sell a stock. Over time, that could add up to thousands upon thousands of dollars of losses and missed profits. You’re not alone †millions of investors fall into the same investing trap every year. But armed with these three secrets to profitable small-cap order execution, you can make sure that you’re on the upside of every penny stock trade. You see, as a small-cap investor, you’ve got very different concerns compared to those who only buy and sell blue chips. One of those concerns is order execution. And most likely, it’s something that you haven’t heard about anywhere else†That’s because for the most part, order execution is a term that’s relegated to the big players †firms like Goldman Sachs and T. Rowe Price that have teams devoted solely to proper order execution. But penny stock investors have many of the same order execution concerns on tiny, thinly traded stocks that the big Wall Street firms do with companies like GE and Microsoft. But before we get down to brass tacks, let’s take a look at what order execution means†Order execution is the process that swings into action when you try to buy or sell a stock. When most investors place an order with their brokers, execution is nearly instant. But when small-caps are concerned, thin trading volume can play havoc with share prices and with your profit or loss. It’s important to remember that as its name implies, the stock market is a market. That means that stocks move based on supply and demand, and not necessarily their intrinsic value. While that works well for heavily traded stocks like Exxon Mobil or Wal-Mart, where thousands of investors keep shares around their fair value by buying and selling millions of shares each day, some small-caps only trade a few hundred shares during any given trading session †some trade even less than that. As a result, penny stock share prices can sometimes deviate pretty far from where they should be. And while that can provide prescient investors with a whole lot of profit potential, it can also be a big problem for those who don’t protect themselves. Understanding Bid-Ask Spreads Like mentioned before, stocks trade in a market. In markets, prices are set by the participants †in this case individual and institutional investors who buy and sell shares of stock. There are two pieces of price information for any stock: the bid, which represents how much investors are willing to pay for a stock, and the ask, which represents how much current shareholders are willing to sell for. When those two numbers intersect, a trade happens. The bid and ask aren’t hypothetical numbers †they represent real outstanding orders. For any stock, there’s a separation between the bid and the ask, known as the spread. If someone’s willing to sell shares of Bank of America (NYSE: BAC) for $16.84 and another person’s wiling to buy shares for $16.83, your bid-ask spread is one cent. The spread is kept small by the large number of traders in the stock, who volley back and forth maintaining a tight range for BAC’s share price. But for a stock that’s more thinly traded, spreads can be huge. That’s a big problem for small-cap investors because a spread that span’s 2% to 3% of a stock’s share price can essentially shear that kind of performance from their position from the get go. And starting out 3% in the red from the second you buy shares of a stock isn’t a good deal†When you’re missing out on 3% of every trade, that disadvantage begins to add up big time. But follow these three secrets, and you can ensure that you’re making out on your small-cap trades: 1. Love Liquidity The best way to avoid being burned by a lack of liquidity is to only trade stocks that have enough trading activity to keep share prices in a reasonable range. And while that may sound limiting to some investors, the truth is that there are ample investing opportunities in small-caps that still see decent trading volume on the market. As a general rule, if a stock doesn’t trade thousands of shares during any trading day, it’s best to keep your distance. 2. Use a Limit Order Market orders are a bad idea for small-cap investors. That’s because they automatically execute at the price necessary to make a trade, meaning that every time you initiate a market order to buy shares of stock, you’re rising up to meet the price the seller wants. With huge spreads common in small-caps, market caps are a sure way to lose money from the get go. Instead, use a limit order. Limit orders are essentially market orders that only execute below a certain price when you’re buying shares, or above a certain price when you’re selling. They’ll help ensure that your entries and exits are happening at prices you set, not the other party. 3. Beware of Promotions Stock promotion is a popular way for small-cap companies to increase daily trading volume. The practice, which often employs dubious ethics, involves hiring firms that spread good news or sentiment about a tiny stock. But being on the wrong end of that strong sentiment can be a very bad thing. Since volume in small-caps is often so thin, the huge volume surges caused by stock promoters can sometimes move a stock’s share price by more than 20%. To avoid getting into stocks that are being manipulated, check out promoters’ favorite places †investing message boards and press release websites †for over hyped language that goes beyond what one of the company’s shareholders would spout off. If you see the same language in multiple locations, chances are that a promotion is underway. The stock market is a tricky enough place to operate. After all, there’s no way to guarantee that the next stock you pick will deliver 100% profits. And there’s no telling whether the company you just added to your portfolio is a sure thing. But even with all of that uncertainty, you don’t have to give away your gains before you place a trade. Now you’ve got three ways to make sure that order execution mistakes don’t squeeze your profits. Cheers, Jonas Elmerraji
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