Stop-Limit Order

WHAT IT IS:

A stop-limit order combines the features of a stop order and a limit order.

Once a stock reaches the stop price, a limit order is automatically triggered to buy/sell at a specific
target price.

HOW IT WORKS (EXAMPLE):

Let's say you bought stock ABC at $50 per share. You don't want to lose more than $5 per share, so
you set a stop-limit order for $45.

If the stock dips to $45, the stop price triggers a limit order to sell at $45. If a rapid price decline
takes the stock lower than $45, the limit order will ensure that you don't sell at the lower price. The
limit order will only execute when the stock reaches $45 again.

This is an important difference between stop-loss orders and stop-limit orders. When using a
traditional stop-loss order, if ABC falls to $45 and triggers the stop price, at that point the order
becomes a market order. If the price continues to fall and is at $42 by the time your market order is
executed, then you will only receive $42 per share.

WHY IT MATTERS:

A stop-loss order can protect you on the downside when the stock market is acting somewhat
normally. But if the market is susceptible to violent swings, when the stop-loss price is triggered, the
order automatically becomes a market order. At that point you lose complete control over the price at
which the trade is executed.

A stop-limit order enables you to maintain some control over the price at which you buy or sell.
But note that with all limit orders, if the limit price is never reached, the order will never be
executed. In the above example, if the stock falls to $42 and never bounces back to $45, your limit
order won't trigger and you'll still own the shares you were trying to sell at $45.

No, High-Frequency Trading is bad for the economy because it reduces the size of investment market and the amount
of investable capital by chasing out non-HFT participants. The primary detriments of HFT are its asymmetric
liquidity profile and its substantial impact on overall volatility.

High-frequency trading does not provide fundamental value to individual investors or to the general price discovery
function. There are some who argue that it increases liquidity, but the liquidity disappears when needed most (when
the market is tanking). A great analogy I heard recently: HFT is akin to someone finding out how much you're willing
to pay for toilet paper and in between the time you take it off the shelf and get to the cash register, they bought and
sold the toilet paper up to your maximal clearing price.

Increasingly, it has been magnifying short-term volatility to the point where individual investors may perceive it as a
signal that a key characteristic has changed for a stock, when in fact it is just a price and volume amplification. HFT
appears to amplify recency effects while reducing investment wisdom. I would like to see analysis of the correlation
between the growth in quantitative trading and the VIX. As the market's volatility increases based on second- and
third-order quantitative strategies, it chases individual investors out of the market as they can no longer understand
its movements. As market uncertainty increases, investor risk tolerance decreases, causing investors to allocate more
of their investment capital to lower risk vehicles. This removes valuable risk capital from the markets and lowers the
country's ability to fund economic growth and innovation.

I believe that the farther a market gets from ownership changing hands because of fundamentally held beliefs about
the value of those assets, the farther it gets from being a socially effective allocator of scarce resources. Eventually,
this will actually reduce the size of the investment market dramatically as average investors are less able to
understand and rely on market stability. What we have left is a market dominated by algorithmic strategies that are
unconcerned with evaluating investments with a long-term view of value.

IMPACT OF HIGH FREQUENCY TRADING ON INVESTORS AND THE ECONOMY

High frequency trading companies, companies that make a profit by anticipating market trends and
buying sought after securities to be resold at a marginally higher price, are growing in prominence in
today’s market. They use complex algorithms and cutting-edge technologies to stay ahead of
competitors. This has stirred up debate as to the effect of high frequency trading on long term
investors and the market as a whole. Although some find the impact of these companies to be
positive, it is evident from many observations that their effect on long term investors and various
security exchange markets is negative.

Since 2006, the methods of trading in the stock market have changed drastically. Trading driven by
algorithms is now more common. Trading using algorithms analyzes market data and uses technology
to execute trades within a fraction of a second. This type of trading, referred to as high-frequency
trading, has since risen to prominence. Current estimates show that 60% of all trades completed are
high-frequency trades, which have profits as high as $2.5 billion yearly (Patterson).

The image (Edwards) below illustrates the rise in high frequency trading as a percentage of
the total volume. Volume is a term that refers to the number of trades made in a market:

Although the data only exists through 2009, the projections suggest that the percentage of volume
has increased through the present day and will continue to increase. Trades made by high frequency
trading companies are likely to account for nearly all trades made in the future.

Many analysts believe that high frequency trading may have a positive impact on long term investors.
Long term investors buy stocks with the intention of keeping them for a long period of time. High
frequency trading increases liquidity, or the ability to facilitate the sale of securities. In this way, they
act as a middle man between long term investors looking to purchase securities. This positive impact
has been documented. Bid ask spreads, the difference in price between what a buyer wants to
purchase a stock at and what the seller wants to sell the stock at have dropped over the last 20 years
(The Atlantic). This information suggests that high frequency trading might actually be beneficial to
long term investors. However, many other measures of the effect of high frequency trading suggest
the opposite.

Rather than attempting to perfect algorithms, high frequency traders compete in efforts to be faster
than others. This emphasis on speed has inspired high frequency trading firms to adopt methods such
as utilizing fiber optic cables for faster Internet connection and occupying buildings geographically
closer to the New York Stock Exchange to cut milliseconds off transaction times. With multi-million-
dollar companies using these finely tuned practices to optimize trading, no small investor or traditional
investment firm can compete in transaction speed with high frequency trading companies (The
Atlantic). Because of these efforts, debate has arisen with regards to the effect of high frequency
trading on long-term investors, High frequency trading companies make a profit by anticipating
purchases made by other investors and purchasing amounts of a certain desired securities to resell at
a slightly higher price to the long-term buyers who initially attempted to purchase them. These
companies pay various exchange companies to see incoming purchase orders so they can insert
themselves into the transaction. Investor Brad Katsuyama discovered that when he placed a purchase
order at an exchange geographically close to him, high frequency trading companies would become
aware of his purchase order and buy up his desired security at all other exchanges with the intent of
selling it back to him at a higher price (The Atlantic). In fact, it has been measured that high
frequency trading companies trade aggressively only at times when other investors do so (The
Atlantic). This marginally drives up the price for long term investors and may limit long term investors
to only purchasing small amounts of stock at the price that they actually wanted to buy at.

From a psychological standpoint, high frequency trading has an adverse effect on the market. High
frequency traders have resorted to methods such as creating false orders to confuse competing
algorithms. Such techniques make high frequency trading appear sinister and complex, which
intimidates other traders due to the perceived advantage high frequency traders have over them (The
Atlantic). Actions such as these are discouraging to long term investors and keep them from making
risky trades or participating in security exchange in general. This exemplifies the negative effect on
trader’s confidence. High frequency trading companies have incentive to trade as much as possible, as
it is correlated with increased profits. The Wall Street Journal describes this practice by saying, “Since
many high-frequency firms make money by scraping fractions of a cent per share traded, the more
shares they trade, the more money they can earn (Patterson).” This is illustrated in the graph below
(Strasburg):

Although this action has increased the overall volume in the stock market, recent analysis shows that,
other than volume generated by high frequency trading, volume has decreased (The Street). This is
an objective measure of the above point. Investment activity overall is decreasing due to a lack of
long term investor confidence in the market. High frequency trading practices are keeping investors
from the market in fear of being taken advantage of. In general, the activity of high frequency trading
companies is crowding long term investors out of the market (Patterson). This is having a negative
impact on the economy as a whole.

Many retail investors today have automatic stops on their securities. For example, an investor may
have their stock in a certain company set to automatically sell if the price drops 10% in a given day. It
is possible for high frequency investing to cause a flash crash, which is a brief but drastic drop in price
followed by a return to the original price (The Street). This could cause investors with automatic stops
to sell their holdings and lose 10% of the shares they held due to an artificial drop in price caused by
high frequency trading. Even if investors don’t have automatic stops to their stock, they may keep
money in funds that have automatic stops (The Street).

Commodities traders use a process called hedging to ensure they can sell their product at a certain
price in the future regardless of the market price. Producers of various commodities pay a price that
varies with the volatility of the market in order to insure the sale of their product at a certain price in
the future. The more volatile the market, the more a producer will have to pay to insure his or her
product. High frequency trading increases market volatility (The Street). This means that commodities
producers, such as farmers, will pay more to insure their product. This increase in price is passed on
to consumers when they buy groceries and the like at the super market (The Street). In this way, high
frequency trading affects anyone who purchases groceries at a super market.

There is much debate today as to the effect of high frequency trading on the stock market and the
economy as a whole. Some say that it is beneficial, as it increases liquidity and overall volume and
makes it easier for buyers and sellers to agree on prices of securities. However, I believe that high
frequency trading has a negative effect on the economy as a whole. Although overall volume is
increased, volume generated by long term investors is declining, which indicates a weaker market.
This counters the point that high frequency trading generates an increase in volume because it shows
that the increase is not meaningful. Also, high frequency trading negatively impacts the confidence of
retail investors. This is a possible explanation for the lack of a meaningful increase in volume as well
as an indicator that high frequency trading is hurting the long term and retail investor. High
frequency trading also hurts the economy in a broader sense by driving up the price of commodities.
For these reasons, high frequency trading is hurting the long term investor and the economy as a
whole.

References:

O’Brien, Matthew. “Everything You Need to Know About High-Frequency Trading.” The Atlantic. 11
April 2014. 25 October 2014.

German, Victor and Zhitnitsky, Igor. “Four Ways High-Frequency Trading Harms Investors and the
Economy.” The Street. 3 April 2014. 25 October 2014.

Edwards, Chris. “High-frequency trading systems – speed vs regulation.” Engineering and Technology
Magazine. 18 June 2013. 25 October 2014

Patterson, Scott. “Study: High-Speed Trading Hurts Long-Term Investors.” The Wall Street Journal. 26
July 2012. 25 October 2014.

Strasburg, Jenny. “A Wild Ride to Profits.” The Wall Street Journal. 16 August 2011. 25 October 2014.
What is high frequency trading or HFT? Put simply, HFT is when an institutional investor has a high-speed algorithm
that is programed to purchase a particular security, and within a millisecond, sell that same security at a fraction of a
penny higher. These trades often occur ahead of some other investor, and allegedly increases the bid / decreases the
offer of that security for that investor, thereby causing the investor to pay more for the trade. According to Michael
Lewis, this is an outrage! But, is this really the whole story? Is it possible that high frequency trading just might be
benefiting other investor(s)? Let's take a look at how an unsuspecting investor might benefit.

I believe that HFT helps squeeze money out of the bid/ask spreads. The trend of squeezing the spreads began on
April 9th, 2001 the SEC required all U.S. exchanges to convert trading from fractions into decimals. Prior to this
change, the minimum spread between the bid and ask was 1/16th or $0.0625 cents. By converting to decimals, the
potential minimum spread became $0.01 cent which was beneficial to all investors, because it substantially reduced
the possible spread that a trader or market maker at an exchange could take for crossing a buy with a sale. In today's
world, HFT has broken this spread down even further, as its commonplace to see trades quoted in 1/100th of a penny
or $0.001. This is possible because of the velocity and quantity of stock available for purchase or sale, in heavily
traded securities, thereby allowing the investor to actually pay less for the trade.

This is simple economics. When an item trades in enormous quantities and velocity, competition for the transaction
will squeeze margins. So on one hand, high frequency traders may, in fact, jump ahead of you on the purchase
of IBM IBM +1.98% and cause you to pay $0.001 more for your stock, but they are also helping to create an
environment where the bid/ask spread was reduced from $0.01 to $0.001, which sounds like a gain to me. In this
case, it appears that the exchange took the hit, not the investor that paid 1/100th of a penny higher for the trade.

Let's assume you are still not convinced. How about market liquidity? Even in today's world of decimalization, it's
possible for stocks to have a bid/ask spread of $.02 or even a whopping $.10 cents per share. Why? This happens
when there is more illiquidity in a stock, where there just aren't enough buyers and sellers meeting together at the
same time. HFT creates more velocity between buyers and sellers, which increases the speed and volume of the
transactions, which gives you a greater opportunity to buy or sell a security, i.e., liquidity. Investors need to
remember that when you go to buy or sell a security, there needs to be a buyer or seller on the other end, to make the
trade happen. If you strip out the HFT, you are potentially stripping away big source of liquidity

Halt the presses! I am an investor and not a trader and none of this noise should matter to me. When I invest into a
company, I plan to hold that investment for a very long time. Should I really care about HFT, when I'm not planning
on trading the stock? I think not. Yes, according to Michael Lewis, I might pay a few cents more for the company that
I just bought, but let's get real. I should be more concerned about what my money is buying, vs. how some other
investor is trying to make a penny around me. I think high frequency traders are taking money from other traders, not
investors. If you want to take most of the potential effects of HFT from your portfolio, then build a portfolio of
individual stocks that can hold for a very long time and limit your trading activities. If you don’t trade in and out of
your companies, you won’t get scalped by a high-speed trader, and you just might even have better overall returns.