Schaeffer's Outside the Box Blog
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What’s the key to turning trading profits? Just trade a lot:

In a new study, Andrei Kirilenko, the chief economist at the U.S. Commodity Futures Trading Commission, along with researchers at Princeton University and the University of Washington, examined high-frequency trading in a futures contract called the e-mini S&P 500, between August 2010 and August 2012.

The study looked at only the expiring contracts (which trade electronically on the Chicago Mercantile Exchange) that are used to bet on the direction of the Standard & Poor’s 500 Index. The researchers also did something they’d never been able to do before: Use actual trading data from individual firms, though none were identified.

What that data does is help explain the frenzy in today’s markets: The most aggressive firms tend to earn the biggest profits, hence the incentive to trade as quickly and as often as possible. Furthermore, these traders make their money at the expense of everyone else, including less-aggressive high-frequency traders.

The study found that the most hyperactive trading firms earned an average daily profit of $395,875 in the e-mini S&P 500 contract over the two-year period. First and foremost among those on the losing end: small retail investors. The study found that, on average, they lost $3.49 on every contract to aggressive high-frequency traders.

OK, let me amend that. Trade a lot, but have all your orders guided by a machine that measures execution time by the nanosecond. And use algorithms that no human could possibly comprehend, much less implement.

It's tough to analyze the impressiveness of that $395K daily profit without knowing the size of the players. After all, Goldman goes some quarters without having a losing "trading" day. The thing is, though, Goldman’s definition of "trading" likely involves taking the other side of a customer when they already have a better bid/offer in their pocket, whereas with algorithms, the one thing you know is that they really do incur risk on their transactions. Of course, Goldman may be included in that number to begin with, we just don’t know.

What’s more noteworthy here is the other side -- the fact that smaller and/or less-aggressive traders get clipped, on average, on every transaction. How bad is that $3.49? You know those offers of 500 free trades that firms make in order to move your account over? The Average Joe will lose $1,745 on those "free" trades. Nice deal when that firm is also doing the algos themselves and just taking the other side.

Alternatively, you could blindly bet football games at -105 (risk $105 to win $100, not atypical terms) and lose an average of "only" $2.50 per $100 bet.

Or, instead of each trade, you could just get a latte at Starbucks. You still won’t get the money back, but at least it solves your caffeine fix.

Obviously people can and do still earn money as small traders. It's clearly better now than it was 20 years ago, as the spreads are tighter and the execution is light-speed faster. It's just that the "spoils" have found their way into the pockets that are already the deepest.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.

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