Stock Market Myths

One of the hottest topics in the mass media today is High Frequency Trading (HFT). Part of the reason for this is a book called Flash Boys, by Michael Lewis. Lewis suggests that the stock market is "rigged" or "manipulated," and that High Frequency Traders are making a fortune by cheating other investors.

Both of these ideas are, well, wrong.

HFT traders try to enter the market a fraction of a second before others using complex mathematical algorithms. They profit from the smallest possible move in prices. Contrary to the claim this hurts other investors, it actually helps them. HFT traders are having a big impact on markets - commissions and spreads are much less than a few years ago.

For example, in the 1980’s it was common to pay a commission of $20 or more to buy 100 shares of a well known stock, and the spread was often 10 cents or more. Today, I pay one dollar commission, and the spread is a penny or less.

Thanks to HFT traders competing for fractions of pennies, spreads are very tight, commissions are low, and the average investor benefits from this. HFT traders compete with each other, not with average traders.

There is one group being hurt by HFT – banks and financial institutions. Perhaps that is why they are making such a stink about it. Commissions and spreads are going down, and that cuts into bank profits. Meanwhile, it helps average investors. As a practical matter, do you really care about a penny or less in the prices of stocks you buy? I don’t.

Lewis’s book also suggested that the markets are “rigged.” This is also wrong.

People who think markets are rigged simply don’t understand them. Markets work exactly like a farmer’s market or a cattle auction. The owner of a stock offers it for sale, and people bid. The highest bidder buys the stock if the seller agrees. That’s all. It’s no different from buying and selling anything else. Got a car to sell? Put an ad on the Internet or in the newspaper. Someone makes a bid, and if you like the price, you sell the car.

The price of a stock will stay at exactly the same level until someone decides to buy or sell. There is no “them” setting prices. The only thing that moves the price of a stock is buying and selling.

I realize this is not as juicy as the story about rigged markets and front running by HFT traders, but that's how it is. Real life is usually not so dramatic as stories about it.