Season Investments


Is Investing a Rigged Game?

Posted on April 8, 2014

“The United States stock market, the most iconic market in global capitalism, is rigged.” – Michael Lewis

This past week the financial press has been enamored with the topic of high frequency trading (“HFT”). Several investigations into HFT were either announced or launched last week by the SEC, the Justice Department (FBI), and the New York Attorney General’s Office. The media blitz started after a 60 Minutes interview with author Michael Lewis (best known for his books Liar’s Poker, The Blind Side, & Money Ball) about his new book Flash Boys. Lewis is well known for his journalistic, storytelling style which brings somewhat obscure topics (e.g. quantitative methods being applied to baseball recruiting) to life for the reader. His latest book seems to be in this same vein as he attempts to unveil the mystery of HFT. Lewis lit the media fire when he started the interview by making the statement in the opening quote of this post indicating that the US stock market is rigged. The embedded 2 minute video below is an excerpt from the 60 Minutes interview providing Lewis' explaination. For those with 15 minutes, we highly recommend watching the entire interview which goes into much more depth on the topic.

As some of our readers might remember, we wrote about HFT back in May of last year in our Insight entitled Trading at the Speed of Light. In the post we gave a high level summary of what HFT firms were doing and how they were making money.

The hold period for a high frequency trade is less than a second, which is why speed of execution is essential for HFT participants where the fastest execution wins and coming in second is the same as coming in last…High frequency trading is done by market participants trying to skim fractions of pennies off of millions of transactions each and every day. Think of a group of very smart people using really expensive computer equipment to develop a system that can predict and profit from the movement of financial securities over very short periods of time.

Where we fell short in this explanation was thinking that high frequency traders had developed an edge but were still taking some amount of risk to make a profit. While this might be the case for some HFT firms, Michael Lewis and former head trader for RBC Brad Katsuyama, tell a much different story in the 60 Minutes interview. Several years back Brad started noticing a rather troubling pattern with all of his executions. Every time he went to the market to buy or sell shares in a size that the market was showing as available, his order would get partially filled at the quoted price and partially filled at a price slightly worse than the quote. This slippage was costing RBC and its customers hundreds of millions of dollars every year. What Brad came to realize was that HFT firms were in essence front-running his trades because of their speed advantage.

When someone enters a trade through a broker, the first place that trade lands is at the BATS Exchange in NJ. Any shares being offered at this location that can fill all or some of the order are immediately executed before the order is then routed out to the 13 nearby exchanges in the NY area. It only takes a fraction of a second for the order to be routed from the BATS Exchange to the nearby exchanges, but that is all the time a HFT program needs to read the order on BATS and then game the trade on the other exchanges. As an example, let’s say an order was placed to buy 10,000 shares of XYZ, the market is currently showing that 10,000 shares are available for purchase at the ask price, and 1,000 shares are available at the BATS Exchange. The 1,000 shares at the BATS will get filled at the market price but before the other 9,000 shares can be purchased from the nearby exchanges, HFT programs will buy up the remaining 9,000 shares, mark them up slightly (sometimes less than a penny), and turn around to sell them to the incoming order that is only milliseconds behind their trade. In the 60 Minutes piece, Brad Katsuyama explains this idea through an analogy of purchasing concert tickets.

Your family wants to go to a concert. You go on to StubHub; there’s 4 tickets all next to each other for 20 bucks each. You put in an order to buy 4 tickets [at] 20 bucks each. And it says, you’ve bought 2 tickets at 20 bucks each, and you go back and those same two seats which are sitting there have gone up to 25 dollars.

This type of scalping or skimming is a riskless trade where HFT programs are simply arbitraging the market in a sophisticated form of front running. This was the conclusion the 60 Minutes piece came to which set off a fiery debate on CNBC pairing Michael Lewis and Brad Katsuyama against the BATS Global Markets president William O’Brien. It appears that Michael Lewis’ camp is winning the battle as the results from a recent SmartBrief poll of CFA charterholders indicated that more than half of the voters felt HFT was definitely harmful to the market (votes will continue to trickle in over the next day or so but the majority have been cast at this point).


HFT programs have the greatest impacts on large institutional investors (hedge funds, pension funds, and endowments) who trade all the time in large dollar amounts. To address this issue, Brad Katsuyama quit his high paying job at RBC last year to launch a startup exchange called IEX. The sole differentiator between IEX and the other exchanges is that IEX routes high frequency trades through a 60 kilometers spool of wire, which slows down their execution and levels the playing field. 

We’re selling trust. We are selling transparency. To think that trust is actually a differentiator in a service business, is actually a crazy thought…right? – Brad Katsuyama

So what does this all mean for average investors and is investing a “rigged” game? Based on the evidence presented above, one might be able to make the argument that the US stock market is rigged. Then again, the term “rigged” is probably overselling it a bit. The HFT skim is very small in the context of an investor’s stated goal to compound real, positive returns over time. Does that mean it should be allowed? Absolutely not. If HFT is found to be a form of insider trading or front running, it should be banned, but in the meantime, it shouldn’t deter investors away from the market or from realizing their long-term investment goals.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.