How Individual Investors Can Take On High Frequency Trading and Win

Flash Boys Michael Lewis HFT Book

Do individual investors really have a chance against HFT?

By now you’ve obviously heard about high frequency trading, (at least in passing). It seems you can’t turn your head without hearing about HFT these days.

For example…

In his new book Flash Boys, Michael Lewis depicts how the deck is stacked against individual investors and self-directed traders. And before that…

Les Leopald also complained about high frequency trading in his illuminating book How to Make a Million Dollars an Hour.

And ZeroHedge makes it pretty clear how home-gamers can’t compete with 1237 winning HFT days in a row. Meanwhile:

hft trader
The Wall Street Journal is actually trying to say HFT is really not so bad. But then just try watching 12 seconds of this HFT portfolio in action and tell me the cards aren’t stacked against you.

At a glance, it doesn’t seem like individual investors can take on high frequency trading firms and win. 

Can they?

Especially since their goals are so directly opposed…

Goals of Individual Investors and Goals of HFT:

Individual investors and HFTs are at opposite ends of the investment universe. Right?

dark pool hft trading

HFT dark pools: adult swim only.

If you’re an HFT firm your goal is basically to  make money every second by using dark pools to front-run institutional orders (or something like that).

On the other hand…

If you’re an individual investor, your goal is probably to accumulate wealth and build your net worth gradually over time. You don’t have any fancy tricks and you’r just looking to earn solid returns without taking on too much risk.

So given these diametrically opposed goals, how can individual take on high frequency trading and win?

Step 1: Accept HFT is Real – And Invest Around It

The good thing about HFT being in the news, is that individual investors can learn more about it. While it sucks to learn the deck is stacked against you, it presents a real learning opportunity.

Individual investors should accept that HFT exists, and learn to trade around it. The easiest way to do that is by being realistic and honest about where you are weak compared to an HFT firm. So…

  • Be realistic about your trading execution. Even if you have Level 2 quotes how quickly can you get filled? If you’re scalping pennies on quick trades you’ll be playing in the realm of HFT. Don’t rely on your execution as the core of your strategy.
  • Be realistic about your time frame. If you want to make a lot of trades trying to scalp pennies you’re going to be battling an HFT firm or two. And the more you trade the more you expose yourself. If you can hold stocks for longer and target bigger moves, HFT isn’t such a big deal.
  • Be realistic about your edge. How are you making your trading decisions? If you’re trading on gut feeling or ill-defined indicators you might get ground to dirt by HFTs. You’ll need an impressive trading system or a fundamental edge.

It should be getting clear that HFT and individual investors operate in completely different worlds. But that’s a good thing. Seriously.

And if you’re realistic with yourself…

You might even realize HFT isn’t that big of a deal for individual investors.

By understanding how high frequency trading firms work you can position yourself around them. Just remember…

You need to be honest with yourself. Appreciate that HFTs are out to get you. And be skeptical of anyone who says great things about HFT firms… Like their alleged “liquidity”… (from zerohedge)

hft liquidity myth

HFT proponents say they provide liquidity. But is it really there when you need it most? Don’t count on those empty HFT promises as an individual investor.

The good news is when you’re skeptical of market structure and careful in your approach, you can start to use these HFT strengths to your advantage. The key is being proactive, having a plan, and knowing when to pounce on HFT-induced irrationality.

Individual Investors Can Win by Embracing What HFT Does Right:

Even though HFT firms might not make things easier for you, there are a couple of lessons individual investors can learn from HFT firms.

For example…

  • Be algorithmic in your trade execution. Don’t be naive in your approach to the stock market. Get clear on a trading plan. And have a clear plan for buying and selling your stocks. Make your if/then plans before the market opens.
  • Focus on making money! You have to give credit to the HFT firms – they make money pretty much every single day. They are 100% focused on extracting profit from the market. That’s almost a little inspiring. So instead of making ego-based decisions be serious about targeting returns.

So now it should be getting clear to you:

Individual investors can really improve themselves by (1) getting more granular with their trading rules and (2) actively looking for opportunities to make money. Even if you’re a long term investor you can still use stock trading techniques to compound your investments.

Now here’s the real secret about how individual investors can take on high frequency trading firms and win…

“Two Investment Strategies Diverged in The Woods”

Throughout this post we’ve talked about the difference between individual investors and HFT firms.

So do you know what the take home lesson here is?

HFT short term speculating

At the end of the day, can you really beat HFT firms at their own game?

Well…

You can choose to obsess over your portfolio every second, and try rolling the dice against the currents of HFT…

OR

You can make smart investment decisions based on calculating intrinsic value of a stock.

In one situation, you’re going to be hopelessly headed off at every turn. And in the other circumstance you’ll have a clear roadmap and nobody in your way. In fact…

The latter scenario might even allow you to use short term market irrationality to your advantage!

So:

Here’s the truth about building wealth as an intelligent individual investor:

Some people can make a living gambling on momentum stocks. But in my experience it’s much less stressful when individual investors focus on finding good businesses at a discount. It’s really the only game you have a fair shot at winning.

Now with that in mind, let’s look at the specific best practice items you can focus on to win in the markets, despite all the high frequency nonsense.

Individual Investing Best Practice to Beat HFT…

individual investing sell target against hft

Learn to pick a sell target and finally get conviction in your stock picks.

If the HFT scare of 2014 has taught us anything, it’s that there are large swaths of the stock market you can’t control.

Instead:

As an individual investor you must focus on what you CAN control, (and try to factor in in a margin of safety for the unknowns).

Next…

Instead of speculating on frothy momentum stocks, learn to calculate intrinsic value of a stock. This is how you get long term conviction in your stock picks and ideas.

Even if all you have is a simple sell target, you’ll be much more oriented to the big picture. And you’ll be able to zoom out from the day-to-day grind of the HFT and hedge fund populated stock market.

Finally:

When you have a solid investing plan based on real fundamental value, you can really be proactive with your investment decisions. Disadvantage becomes opportunity. And that’s how you really win against HFT.

You wait in the weeds. And strike when the ebb and flow of short-term irrationality goes in your favour. You take advantage of illogical price jumps to cash in on quick capital gains. And you use unwarranted pullbacks to lower your cost basis in your favourite long term stocks.

Of course: Investing like this isn’t always emotionally simple. But it’s not exactly complicated either. Just focus on what you can control and don’t confuse random noise with something meaningful. If you have trouble with keeping your cool, check out a book like Trading in the Zone.

The truth is: You probably know more than you think.

So take a step back. And re-evaluate where you are relative to the high frequency trading firms. If you’re an individual investor diligently trying to build your wealth you already might be better off than Flash Boys would have you think.

And By The Way: If you’re still a little unsure about how to get high conviction stock picks you might enjoy my free ebook. You can download it for free using the form below. And you’ll see exactly how I developed an Intelligent Investor style approach, with swing trading techniques to exploit HFT-induced irrationality. You’ll also get free tips and tools each week to help you make smarter stock picks. What’s not to like?

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