Monday, September 10, 2012

Light-Speed Traders Compete for Your Pennies

Wired Magazine had an interesting article recently: Raging Bulls: How Wall Street Got Addicted to Light-Speed Trading. It tells the story of how quant firms compete over fractions of a penny per share in computer algorithm trading. They go to great lengths to shave milliseconds off computer communication time to get an edge on their competitors. This article gives some insight into where your trading spread losses go.

To get their trades executed as quickly as possible, high-frequency trading firms go to great expense including buying up land allowing them to install shorter fiber-optic cables, and in the future “A fleet of unmanned, solar-powered drones carrying microwave relay stations could hover at intervals across the Atlantic.” They do all this to grab fractions of pennies faster than their competitors.

All this raises the question: whose pennies are these quants fighting over? To some degree they are stealing from each other, but they are also taking pennies from couch potato investors like me. If you use your 2012 maximum RRSP contribution of $22,970 to buy the exchange-traded fund XIU, you could buy 1300 shares (at the current price as I write this article). The bid-ask spread is one penny. This makes the total spread $13. With each trade you lose roughly half the spread, which makes 650 pennies for the quants to tear apart and gobble up.

Looking over my trades for the past year, I donated about $96 in spreads to the quants’ cause, and I expect this to be less in future years now that I’ve almost completely sold off individual stocks. My guess is that light-speed traders would starve if they had to survive on contributions from investors like me. Fortunately for the quants, there are plenty of individuals who try to make money with frequent trading and contribute much more in spreads than I do.

Whenever you’re tempted to trade in an out of stocks because you think you’ve found the secret formula for success, it’s useful to imagine thousands of computer algorithms ready to take away a slice of your money.

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