Investors Can See Narrowed Price Spreads – Another High Frequency Trading ‘Benefit’ Denied!
Although price spreads have narrowed through history, investor, you can’t have this high frequency trading benefit! In fact high frequency trading actively serves as an impenetrable barrier that stops investors from benefitting from narrowed price spreads. This is yet one more high frequency trading ‘benefit’ that you can’t have!
Before high frequency trading permeated markets, an astute investor or a financial advisor buying for a client could hope to pick up stock positions at less than ask prices. Now, high frequency trading eliminates possibilities of buying at more favorable prices.
Narrowed price spreads touted as another benefit to markets by advocates of frenzied high speed trading are a fictional benefit to buy side investors. The narrowed spread certainly exists, but you can’t benefit by taking advantage of them. Incredibly, high frequency traders are both the cause and effect!
This post continues the White Top View Series, High Frequency Trading. Our discussion continues exploring major myths of high frequency trading. Author, Michael Lewis, in his book, Flash Boys, started the first serious public discussion of the secret investor rip off by high frequency trading activity. The CBS News program, 60 Minutes, Exposed! Market Rigging and High Frequency Trading, based on the same book, inspired us to make more investors aware of markets rigged by technology!
Further posts will cover how investors defend against market predation. Links to all parts of the White Top View Series, High Frequency Trading are at the end of this post.
Previous posts in this White Top View Series, discuss the first three of the four major mythical benefits. Those three mythical benefits included, better volumes, superior price discovery and market making. This post discusses the benefit of narrowed price spreads. The high frequency trading benefit that you can see, but can’t have!
High Frequency Trading Narrows Price Spreads
For decades, price spreads have narrowed as markets evolved. Electronic trading, including high frequency trading continue the process of narrowing price spreads. That narrowing process started long before electronic trading existed. Claims that price spreads have narrowed due to high frequency trading are real. But not something new or unique. However, now, high frequency trading spreads can narrow to the point that you can’t even see most of this activity!
Well, so what! Narrowed price spreads are the high frequency trading benefit that you can’t have! Almost all buy side long-term players, large and small, see no such benefit!
Some Price Spread Background
First, we need to understand basic price spreads, than we can discuss the real high frequency trading benefit that you can’t have!
When you ask for or see a stock price quote, as an example: $49.79 – $49.83 last $49.83. This quote means a bid price of $49.79, an ask price of $49.83 and the price of the last share traded was $49.83. In this example, the spread is $0.04.
Price spreads are the difference between the bid price and ask price for a share. The bid is the highest price on a market order from a prospective buyer. It is the lower of the two prices.
The ask price is the lowest price on a market order from a prospective seller. The ask price also gets referred to as the offer price; a seller offers the stock to prospective buyers at that price. It is the higher of the two prices.
Some new investors get confused about what an offer price means. When dealing with prices on a stock exchange, the offer price is the ask price, not the bid price. Making that distinction avoids confusion.
Thinking or expressing an offer as a price bid for a share, as you may offer a price to buy a car or for an item at a garage sale, does not apply when buying and selling on a stock exchange. Simply think and express yourself as either bidding to buy or asking to sell. That avoids any confusion over what an offer means.
Investors, Galleons, Pirates and Decimals
Long before modern pirates rode algorithms and fiber optics to attack investors, cutlasses and cannons looted doubloons from galleons on the Spanish Main. Those gold Spanish coins of four centuries ago formed the base for trading spreads long before stock markets adopted the decimal system!
Subdividing doubloons into eighths facilitated trading. Eighths let traders use their eight fingers to signal bid and ask prices. That allowed price indications, negotiating and deal making in the noisy, crowded environments which are very typical when humans trade.
Fast forward to the modern era; the doubloon became a dollar and the eighth became $0.125 or 12 and 1/2 cents. As the smallest trading fraction, an eighth or finger, became the smallest spread. Spreads could be greater, but not less, than an eighth.
In small volumes, differences of an eighth may seem inconsequential. But in large lots that could mean gigantic price differences. In time the numbers of shares held and traded grew. That made price spreads very significant. Markets introduced sixteenths, in response. Halving or narrowing the spread to $0.0625 or 6 and a 1/4 cents introduced the newest technology, a half finger sign!
With the passage of more time, funds and holdings grew ever larger. In centuries past a few hundred or thousands of shares ranked among the largest positions held. In more recent times, it became more common that large fund holdings totaled millions of shares. Trading a million shares meant the smallest spread of one sixteenth could exceed six figure dollar amounts!
By April 2001, all resistance to change passed and every market moved beyond vulgar fractions to fully adopt decimal based trading systems. A vulgar fraction simply means common fraction; it is so much more fun to call it vulgar!
Constant Change Continues
Moving to the decimal system immediately narrowed price spreads. Combining the decimal system with two other irresistible forces, accelerated the trend of ever narrowing price spreads. Those forces were:
- Electronic trading
- Investor ownership of stock exchanges
Electronic Trading Mutants: High Frequency Trading
Spurred by the crash of 1987, stock markets embraced the steady march towards the inevitable, full electronic trading. Numerous mutations and derivatives of basic electronic trading applied advanced technology. The high frequency trading umbrella covers many useful and legitimate electronic trading systems. However, many more predatory mutations of the evolution routinely prey on all real, from the largest to smallest, buy-side investors.
Sit Here, No Don’t – The Seat Is Gone!
In the past, a stock exchange seat was an asset needed by brokers to trade on an exchange. Originally stock exchanges were mutual organizations owned and funded by brokers purchasing seats. The seats were the collective ownership, control and had the exclusive right to trade on the exchange. They were effectively an exclusive insiders club of gatekeepers that had access to the exchange.
All others accessed the exchange by paying tolls or fees to seat holders. The value of a seat was directly tied to the money-making opportunity possible through access to the exchange. Trading and collecting fees from investors wanting to buy and sell stocks on the exchange was a lucrative business. The seat cost was the price of access to that business opportunity.
The exchange business evolved and radically changed when exchanges sold shares in themselves to investors. Selling their shares to investors made them like any other corporation listed on a stock market. That made stock exchange seats a footnote of history. Exchange managements became accountable to investors, not seat holders. That changed the business dynamic!
Investors seek a direct return on investment; they do not buy shares as an opportunity to do other business. Exchange managements immediately and directly pursued revenue and profit in a fee for service model. They charged for trading and importantly, sold both information and access in many rapidly evolving forms. Exchanges relentlessly pursued trading and share volume.
Then, September 2008 came. The world changed. In another post we will discuss the financial drama of 2008. This time we stay with our price spread discussion. That fateful September began a period of plunging transaction and share volumes. Exchange managements were so desperate for volume they began paying for it! Those payments became feed helping the high frequency trading monster grow!
Investor You Can’t Have This High Frequency Trading Benefit!
Well experienced investors, traders and financial advisors paying close attention to market action, are well aware high frequency traders see to it that no buy side order gets filled at the bid in rising markets. In times past, some regarded a price halfway between the bid and ask as the fair price. Most conservative valuations use the bid price to calculate the value of holdings as it is the lower price.
However, none of this matters when you must always pay the ask price. Spreads of a penny, a dollar or 10 dollars simply don’t matter if you can only buy at the ask price. High frequency traders pick off all other buying opportunities before you can even see them.
Narrow price spreads bring no benefit to you or any other long-term investor. In fact, this benefit is a double illusion of high frequency trading. Not only can you not have the benefit, it is high frequency trading itself that makes certain you and other buy side investors never benefit from any narrowed price spread!
Incredibly, high frequency traders are both the cause and effect! Any price spreads narrowed by high frequency traders are illusionary for investors. The technology high frequency trading parasites have the effect of making certain no buy side investor benefits! Investors see no significant calculable benefit.
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Links to the White Top View Series, High Frequency Trading
Part 2: High Frequency Trading and You