3 Simple Steps to Beat a “Rigged” Stock Market

Best-selling author Michael Lewis made headlines last year when he argued in his book Flash Boys that “the stock market is rigged.”

Lewis points out that high-frequency traders use sophisticated computer algorithms to execute orders in a fraction of a second, effectively front-running the rest of us.

This is often true.

[ad#Google Adsense 336×280-IA]In a recent interview, he complained that a) nothing has been done about the problem and b) the lack of furor from individual investors is inexplicable.

However, there’s a good reason nothing has been done and there isn’t any public outcry.

Lewis is making a mountain out of a molehill.

Yes, high-frequency traders have a clear technological advantage.

And they are making a bundle of money with it. But the effect on you and me is miniscule.

High-frequency traders are essentially vacuuming up nickels every day. They make tens of thousands of trades on millions of shares, gaining a penny advantage here and a two-penny advantage there.

You probably wouldn’t blow your top if you discovered one day that a kid had grabbed the change out of the ashtray in your car. That’s about the annual effect these guys have on your trade executions.

What’s more, the extremely high level of volume they generate narrows the spread on thousands of stocks to as little as a penny a share. You could argue that their real net effect is to save you money.

However, if you find high-frequency trading alarming, there are three simple steps you can take to do a complete end-run around them.

No. 1: Don’t Day-Trade
I would tell you this – as I did more than 15 years ago when this first became popular – even if high-frequency trading technology didn’t exist.

Day trading is gambling, pure and simple. Over any decent period of time, share prices follow earnings. But in a single session, stock prices are a total crapshoot, moving up and down on all sorts of factors that are completely divorced from corporate fundamentals.

An ordinary investor who is repeatedly trading in and out of stocks during the day is playing a foolish guessing game. (And may even have a gambling problem.) The folks making dozens of trades a day are the ones most affected by tiny price manipulations.

If high-frequency traders caused you to give up your day-trading habit, thank them. They did you a big favor.

No. 2: Always Use a Limit Order
If a stock you want to buy is trading at $25.50, don’t put in a market order and then act surprised when you get a fill at $25.52. Put in a limit order at $25.50 and wait a few minutes. If you don’t get an immediate fill, the stock may be moving higher. So get another real-time quote, cancel your original order and adjust your limit. You’ll get your fill.

If you don’t use market orders, high-frequency traders can’t affect your execution price.

No. 3: Base Your Sell Decisions on Closing Not Intra-Day Prices
Flash crashes and high levels of intraday volatility caused The Oxford Club to stop recommending the use of intraday stop orders.

It’s a bit unsettling to see a stock open at $20, trade down to $16.50 and then close at $19.75.

Base your sell decisions on closing prices and no market maker or high-frequency trader can pick you off at the intraday low. There is a chance, of course, that stocks may close at the day’s low. But you have eliminated the risk of getting knocked out in a volatile session before the market (or your stock) recovers.

In short, Lewis is wrong. The stock market isn’t rigged. That’s why there isn’t any outrage. That’s why no one has been prosecuted. That’s why there haven’t been any regulatory reforms.

Even if you’re a skeptic – or a conspiracy theorist – follow the three steps I’ve outlined here and you won’t have a reason to even imagine you’ve been wronged.

Good investing,

Alex

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Source: Investment U