...in competitive markets, high profit margins don't persist
A couple of the markets Dixon identified are not competitive, namely credit cards and mutual fund management [1].
But quite a few are highly competitive and don't have high profit margins: retail banks, market making (HFT) and research, for example.
Prop trading is also highly competitive, but profits are high because the risk is high as well. Dixon explicitly advises individuals not to compete with the big players because they will probably lose. It's hard even for big players - remember AIG, Lehman and Bear? Thousands of hedge funds went under, so many that the big banks had to lay off most of their prime brokerage divisions.
[1] Mutual funds benefit from an agency problem - your employer selects which funds you can put your retirement into. I'd love to buy low cost ETF's, but then I wouldn't get the tax advantage.
The stock market functioned perfectly well (well, you know what I mean) for 100 years before HFT came about. Now that it's here, does the stock market work better? No, it works worse, if anything. It's just another way for insiders to win by rigging the game.
My problem with Wall St and seemingly Dixon's is that it's all about rigging things to your advantage rather than competing on quality. HFT doesn't create value, it just agglomerates wealth to those with servers in the right colos. Mutual funds and credit cards, as you say, are optimized towards leveraging an immovable market position to extract money from the rest of the economy.
If someone on Wall St is creating value commensurate with their salary, I'm all about that. But it seems like the vast majority are extracting their salary from the rest of the country as an effective tax on investment rather than actually creating wealth.
Why do you believe the market works worse than in the past? I'm genuinely curious why you think this, because based on what I can see, the market is vastly more efficient today.
In the past, you'd pay a market maker 1/8 or 1/4, and even then only in thickly traded securities. In thinly traded securities, your order might just go unfilled. The market makers were humans with a physical seat on the trading floor rather than a server in a colo and you'd pay your broker $100/trade (assuming you could get him on the phone).
Now you pay a $0.01-0.02 spread, maybe $0.10 on thinly traded securities. You pay your broker $0-$10/trade and you can trade from your N1 or iphone. A colo server is also much cheaper than access to the physical trading floor.
HFT provides value: liquidity and immediacy. If you don't believe that is worth $0.02, you can place ALO orders and you won't need to pay for it.
Because it penalizes people who want to buy a stock based on company quality and either hold it or swing trade.
Let's disambiguate 2 developments here : There's the computerization of market-making, which leads to efficiency gains and transparency gains, allowing trades to be fulfilled more cheaply and for more bids/asks to be visible at a given point in time, adding liquidity. None of that really constitutes "high frequency trading" in my mind, more just the inevitabilites of IT.
Then there's stuff like front-running, or micro-arbitrage where the first one to the post wins the money. Are these fulfilling a need that didn't exist before? Or is it just a large amount of money being invested by brokerages in order to extract a larger amount of money from people without servers in the right places? My instinct leans towards the latter. It's not like 1/4-second price inconsistencies were creating some huge problem before. I don't even notice 1/4 second, and the stock market shuts down at 4pm anyways. Prices don't have to be a continuous curve.
If I don't believe HFT provides value, I can go spit up a rope -- it'll still eat away at my margins if I try to invest based on value. God help me if I tried to day trade or swing trade.
As far as "works worse than in the past", I did qualify with "if anything", but to my mind it's become less reflective of the value of companies and more reflective of the current state of various algorithms, which may or may not have anything to do with company value. I see that as a recipe for bubbles and calamities.
You believe HFT is bad because it makes swing trading and day trading unprofitable?!? Fun fact: they aren't unprofitable, since the algorithmic traders you criticize are swing trading and day trading. It sounds like your complaint is simply that machines do a better job than you.
Concering micro-arbitrage, if you don't notice 1/4 second price inconsistencies, you also won't notice if computers resolve them in 1ms rather than a fast fingered human resolving them in 1/4 sec. The money is being extracted regardless, the only difference between now and the past is that a geek with a computer beats the fast fingered frat boy. That's bad if you were the human trader, but who else is harmed?
Front running is illegal and has been for a long time. I'm also not sure how you think HFT traders do it - do you think HFT firms have trojans which alert them when your mouse is hovering over the "place order" button at etrade?
I'm really curious how you believe HFT will "eat away at your margins" if you make long term value investments. If you believe apple will go up 20%, do you really care about the $0.01 spread? Even if you care, how can the HFT guys make money off you if you place an ALO order? Could you explain the mechanics?
I think HFT is bad because it substitutes "create value" for "game the system".
I won't miss the .01 that much, but if they do it a billion times.. they still didn't create anything. They just extracted money from the system while producing zero value.
EDIT: As far as who's being hurt? All of us. Smart people should be creating value, not playing silly parlor games against each other for money. We're all missing out by making a video game more profitable than creating things.
I actually agree with you on the component of HFT/speculation in general that is fighting over the distribution of profits rather than creating profits (i.e., beating other traders to the punch); this creates no new gains. Of course, once we reach the point where most of HFT/trading is fighting over distribution of profits, we've reached the point where it is barely profitable. Presumably smart people will start exiting in droves at that time - I certainly plan to do so.
But I suspect that the transition to HFT over human market makers/daytraders is a net gain even with regards to smart people creating value; isn't it a good thing to have 3 geeks writing programs to replace 100 daytraders? (Based on your previous comment, I assume you agree with me that profitable day/swing trading does create value.) In general, isn't replacing lots of humans by a few smart people + machines a good thing?
Well, if we're down to the portion of HFT/speculation that's extracting gains rather than contributing to the economy, we've made it pretty far.
As far as robots running the stock market -- I don't know. Frankly, I'm inclined to be awfully conservative about the stock market at present. If you told me we were going backwards 5 years in technology and there'd be way less money made on the stock market, I'd probably be ok with it, for a few reasons.
1) Frankly, I'd rather be conservative on cutting edge approaches to stock pricing for a little bit.
2) To my mind, the stock market doesn't exist to enrich participants, it exists to efficiently distribute capital. Enriching participants is good motivation, but it shouldn't be legalized gambling and game playing. If an unreasonable share of that capital is going to the console cowboys rather than being distributed to companies and investors (not traders), then something's wrong there. I'm not sure if we're at that point but I don't like the trend.
3) As I said upthread, I don't understand the gains for the economy as a whole of smoothing out the price curve in the sub-second range. I really don't. Anybody who's going to spend a lot of money on something takes more than a second to make up their mind, right? They probably had to get it budgeted and everything. So the subsecond trading on, say, commodities seems to me to be at the expense of actual purchasers of commodities. The gains have to come from somewhere, right?
In general, I'd settle for slower, dumber and less profitable day traders if the upshot is less risk to the system, greater portions of investment gains going to grandma and a more deliberately moving stock market. I'd be fine with that state of affairs, despite my general drive towards futurism on anything else.
I don't understand the gains for the economy as a whole of smoothing out the price curve in the sub-second range.
I'll make it simple for you. There are none.
HFT traders as a whole make no gains from trading in microseconds as opposed to milliseconds or even seconds. If an investor wants to buy 100 shares right now with a spread of $0.02/share, market makers will earn $2.00 over the next few seconds. The only question is which market maker will earn the $2.00, and the answer is whoever is fastest.
Trading fast doesn't increase profits, all it does is redistribute them. Of course, one HFT firm could also outbid the rest, lowering the spread to $0.01/share and allowing the retail investor to pay only $1.00. That's why competition among HFT firms is good.
But you are correct that all the effort put into lowering latency (rather than improving trading strategies) is a deadweight loss to society.
A couple of the markets Dixon identified are not competitive, namely credit cards and mutual fund management [1].
But quite a few are highly competitive and don't have high profit margins: retail banks, market making (HFT) and research, for example.
Prop trading is also highly competitive, but profits are high because the risk is high as well. Dixon explicitly advises individuals not to compete with the big players because they will probably lose. It's hard even for big players - remember AIG, Lehman and Bear? Thousands of hedge funds went under, so many that the big banks had to lay off most of their prime brokerage divisions.
[1] Mutual funds benefit from an agency problem - your employer selects which funds you can put your retirement into. I'd love to buy low cost ETF's, but then I wouldn't get the tax advantage.