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Is U.S. Stock Trading Rigged?

In his new book, Flash Boys: A Wall Street Revolt (W.W. Norton & Company, 2014), Michael Lewis, author of   Moneyball and The Big Short, says stock market trading may be rigged by so-called high frequency traders using supercomputers.

'Flash Boys' by Michael Lewis

During an interview about his book Sunday on CBS's 60 Minutes, Lewis discussed the impact of high frequency trading in what's known in the brokerage world as front-running. To explain what this is, let's say you wanted to buy 100 shares of Exxon Mobil that were being offered for sale at $97.68 a share. Yet after putting in your order to buy the shares at the market price, you find you actually paid $97.70 a share.

Though you might chalk this up to bad timing since the stock price was going up, what really happened, according to Lewis, was that high-speed supercomputers saw your order and in a matter of microseconds, put in an order to buy the shares at the lower price and then sold them to you at the higher price. A more in-depth explanation can be found in this Bloomberg article.

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In this example, the extra cost was only 2 cents per share (or $2.00 for the 100 shares), yet it adds up when it comes to a few billion trades. The average daily trading volume for the New York Stock Exchange alone over the past three months is nearly three-quarters of a billion shares. One hedge fund manager estimated that front-running was costing his firm $300 million annually - which, coincidentally, is what another firm spent on a computer network to shave three milliseconds (three thousandths of a second) off its trading times.

All of this is legal according to sources Lewis interviewed, although the New York attorney general and the Commodities Future Trading Commission have launched investigations. A new stock trading venue called IEX Group was recently formed to prevent what it calls "predatory trading."

Not everyone agrees that front-running is bad for investors, and they argue that it brings more liquidity to the market, meaning that the costs of trading are far less. According to the discount brokerage firm Charles Schwab, commissions on stock trading in 1975 were a hundred times higher than today. Matt Levine makes a case that high-frequency traders actually are heroes.

What this means to you

If you are a day trader, or even moving in and out of stocks several times a year, your odds of success are lower when stacked against supercomputers that can trade more quickly than you can blink your eyes. Ultimately, you are merely feeding these firms your hard-earned money. The odds of beating a low-cost index fund (such as one that owns every U.S. stock) were always pretty low. I view frequently trading stocks as speculation rather than investing.

The impact of front-running on investors who own the entire U.S. market via low-cost index funds is minimal. When buying a mutual fund, investors pay a price equivalent to the net asset value per share, which is essentially the value of all the stocks it owns divided by the number of outstanding shares. The front-runners can't profit here. If you buy an exchange traded fund (or ETF, which is like a mutual fund that trades on a stock market), there are bid-ask spreads that can leave investors subject to front-running, though the impact should be small if the ETF is held for several years.

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While the effect on individual holders of funds is small, even an index fund must buy and occasionally sell the stocks the fund owns. Thus, if their computer network isn't as fast as others, they can be feeding these front-running firms and you can indirectly be paying for this. It's yet another reason to buy funds that have low turnover, meaning that they don't often trade stocks. You can look up a fund's turnover online at Chicago-based Morningstar, and I recommend sticking to funds that have a turnover of less than 20 percent annually.



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