Both in Australia and overseas it seems the listed equity markets are increasingly being dominated by high frequency or Robo trading.  High frequency trading is where firms and individuals use sophisticated computer algorithms to trade financial markets based on high speed, high turnover and high order-to-trade ratios.  They are unconcerned about the fundamentals of the underlying stock or contract that they are trading, but rather the computer program makes decisions based on short term market movements and volumes.

While it is hard to accurately measure the amount of trading volume that is due to high frequency traders, it is estimated to account for over 50% of volumes on US exchanges1.  In Australia the proportion is significantly lower than this at around 27%, but is growing, particularly in futures markets2.  Given their high levels of activity, high frequency traders provide a good source of revenue for the companies that run the exchanges, therefore most stock exchanges have been very supportive of high frequency trading despite some concerns about their growing dominance of turnover.  Proponents of high frequency trading argue that they provide liquidity and depth to markets and assist in price discovery.

However it is becoming increasingly apparent that the increase of computer based trading lead to an increase in the size and amount of short term market volatility and extreme market displacements such as the “flash crashes” that are occurring in markets when either algorithmic program malfunction and send distorting orders into the market or in periods of extremely low liquidity where automatic orders cause disorderly trading.  Of probably greater concern to regulators is the potential for misleading market signals being sent, particularly where high frequency traders place orders and then remove them in rapid succession.  This may directly, adversely affect other market participants.

As fundamental investors it can be frustrating to see markets increasingly moving based on such short term relatively irrelevant information pushing stocks to what can seem extreme valuations (both high and low).  However, given the changes in technology and the position high frequency trading now has in the industry, this method of trading is not going to diminish.  Therefore it is important to use the volatility created by high frequency and electronic trading to the advantage of the long term investor.

The first way to do this is to step back from the noise and understand the fundamentals of the COMPANY you are investing in.  At the end of the day we are investing in companies not stocks and are buying a share of the future earnings of these companies.  By doing our research and due diligence on the current and future prospects of these companies we can have a greater degree of confidence in the real value of those future earnings, rather than the minute by minute value put on them by the latest market movements.  This puts us in a position to take advantage of discrepancies between the value of the company and the share market price.  Where they are overvalued we can look to sell and take profits and where there is value created we can buy cheaply.

This leads to the second factor required and that is patience.  With the increasing dominance of momentum trading and disappearance of value investing it is more important than ever to have patience in investing.  This is particularly true in picking exit points in stocks.  It can be too easy to take profits too early or to second guess investment decisions if the market is constantly disagreeing with you.  It is important to remember that most of these algorithms do not take into account the company fundamentals and therefore are not making a judgement on the worth of the company.  It is very hard for stocks to turn around negative momentum and market sentiment, but when this occurs it can provide some of the most rewarding investing opportunities for the patient investor.

1 ^ Times Topics: High-Frequency Trading, The New York Times, December 20, 2012
2 Australian Securities and Investments Commission 2015

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