How You Can Beat the Stock Market Scalpers

By MoneyMorning.com.au

You’ve probably heard the growing furore surrounding high–frequency trading (HFT).

It’s been hard to miss the stories.

They’ve come with sensational language like ‘looting investors’, ‘rigged market’ and ‘traders’ conspiracy’. It’s a headline writer’s dream.

But it’s a private investor’s nightmare.

Shareholders around the world are fretting about how HFT could impact on their investments.

Stock market pundits are fanning the flames, clamouring for governments to clamp down.

So, how should you react to HFT? Is it possible for a private investor to beat the speed demons who trade stocks with lightning–fast computer programs?

Well, if you follow my advice, yes, it’s absolutely possible. Let me explain…

American financial journalist Michael Lewis has led the charge against HFT.

Mr Lewis has just released a book, Flash Boys, in which he details the perfectly legal ways that brokers take advantage of everyday investors. His previous books include Liar’s Poker and The Big Short. Because Mr Lewis is a famous, best–selling author, his latest book enjoyed a lot of build–up and the mainstream press gave it a big push.

According to Lewis, HFT is just one of the many ways that big institutions squeeze real money out of everyday traders.

But what is HFT?

Simply put, it’s when a tech–savvy and deep–pocketed player uses high–powered computers to analyse short term market trends and then trade on them faster than a human possibly could.

The software can buy and sell a stock at speeds 100 times faster than the blink of an eye. Each time, the owner gets a tiny profit. But when you trade as frequently as these guys do, and in such large volume, those profits can grow from tiny to titanic.

It’s not too far removed from the penny–shaving scheme that Richard Pryor’s character employed in Superman III.

Here’s where it gets dodgy. As Mr Lewis points out in Flash Boys, some firms have spent billions on dedicated connections that let them see pending trades coming from slower data streams.

That means their software can see incoming buy orders before they hit the market. The HFT firm can then make its own high–speed trade in the knowledge that the slower order will be executed milliseconds later.

Since the computer’s order will increase the stock’s bid price, the HFT firm can essentially buy the stock more cheaply than the hapless investor who sent their order down the slow lane…and sometimes even sell the stock to the slowcoach in the next instant. At the higher price, of course.

In short, the HFT firm forces lots of investors to pay tiny amounts more for their stock than they should have, and pockets the difference. In other words: they scalp the market.

This has been going on since long before Michael Lewis threw the cat among the pigeons.

The chart below appeared in The New York Times almost five years ago. Not much has changed since then. It still clearly demonstrates the advantage that HFT operators enjoy over slower players.

Source: The New York Times

But the principle at work here is much older.

The search for speed is a logical extension of what the Rothschild banking dynasty was getting up to more than two hundred years ago.

In the early 1800s, the Rothschild family used carrier pigeons to relay price–sensitive information. It’s said that the Rothschilds got the early mail regarding the outcome of the Battle of Waterloo. That let them fleece the UK bond markets before their competitors got a look–in.

The fact is if you want to make money in any market, fast information gives you a critical advantage. That’s just the way it’s been ever since the ancient Babylonians traded barley.

And yet some pundits are calling for governments to limit or ban HFT.

I disagree with that. Think about it. Do you really want the government dictating exactly how companies and investors can trade with each other?

If so, where does it end? Should one able–bodied investor be penalised by the government because he or she can click the ‘buy’ button faster than a person who isn’t as nimble with a keyboard and mouse?

Sure, that’s an extreme example. But if we let the government throttle commerce like this, it’d take us down a dangerous, expensive and unproductive path.

Inside tips to beat HFT

There’s plenty of heat and noise surrounding this issue. But common sense should still prevail when it comes to dealing with HFT.

So how do you beat the scalpers?

The short answer is this: don’t play their game.

There are only two sure–fire ways that you can avoid getting picked clean by HFT operators.

What’s more, they’re both simple solutions.

Regardless of which solution you choose, here’s an inside tip.

Some retail brokers sell out their customers by diverting their orders and letting HFT strategies pick them apart.

It’s worth executing your trades exclusively through ‘smart’ brokers. These are the ones that let you search for liquidity without signalling your intentions to the market.

HFT preys on the most vulnerable players in the stock market. This helps you make sure you’re not one of them.

Now, to beat the scalpers…

Option 1: buy and hold stocks for the long term.

If you only buy and sell stocks infrequently, you give high–frequency investors far fewer opportunities to make money out of you. If you simply hold a stock, there’s no way for them to profit at your expense.

But here’s how you can get a real edge.

Aim to know the value of what you’re buying. That’s something the machines don’t care about and don’t know.

Grasping the fundamentals of valuation will set you on the path to long term investing success.

Option 2: smaller is better.

HFT firms use huge amounts of money to take advantage of tiny price moves in heavily–traded stocks.

So the simple solution is to avoid the kind of stocks that they target.

That means turning away from the blue chip large–cap stocks whose names you hear on the evening news.

I’m talking about focusing on companies that are small enough to avoid the computer screens of the big trading houses.

Of course, I’m a stock analyst who focuses on the small end of the market, so I must disclose a certain bias.

But this is a big part of what excites me about picking winning small–cap stocks.

I’m always on the lookout for companies that are unloved or under the radar of mainstream analysts. These are stocks that I know techno–savvy share scalpers aren’t interested in.

Small–cap stocks are inherently risky and you should never invest more in speculative punts than you can afford to lose.

But here’s the point. If you trade through a big name broker to buy well known stocks, you might be losing money to deep–pocketed institutional investors every time you make a trade.

But if you look for stocks that the big guys won’t touch…the scalpers aren’t as likely to take a cent out of your pocket.

Cheers,
Tim Dohrmann+
Small–Cap Analyst, Australian Small–Cap Investigator

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