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Michael Brush

Company Focus8/28/2009 12:01 AM ET

Wall Street's high-tech war on investors

A PC can be an investor's best tool. But as a vast high-tech arms race unfolds, big brokers and hedge funds are using their computers to take unfair advantage.

By Michael Brush
MSN Money

PCs, broadband Internet connections, online brokerage accounts. These advances brought democracy to Wall Street, leveling the playing field between everyday investors and the insiders, right?

Wrong.

In fact, computers are ruining investing for the average investor.

Sure, your PC lets you see when your stock is moving. But multiply its computing power by thousands, add a throng of software geniuses earning more than $1 million a year and an army of full-time analysts, and you start to understand how the biggest brokerages and hedge funds can stay a few steps ahead of any move you can make.

Yes, you can trade from your cell phone while waiting at a traffic light. But at the big hedge funds, computers execute thousands of trades in milliseconds --and cut into line ahead of buyers like you and me, our mutual funds and our brokers.

All this helps explain why your portfolio was likely hemorrhaging money as stock markets tanked in the first quarter of this year -- yet elite traders at Goldman Sachs (GS, news, msgs) were creating near-record profits.

Tricks of the trading

You won't be surprised that your home computer pales compared to systems honed by the Wall Street elite at places like Goldman Sachs, Citadel Investment Group and Renaissance Technologies. But you might be surprised at what they do with those systems to get an edge over you:

  • Scour the markets for opportunities and make millions of trades in less time than it takes you to hit the "enter" key.

  • Take advantage of exclusive "flash orders" to trade stocks at better prices than you'll ever see.

  • Fish for profitable stock bargains inside exclusive trading venues called "dark pools," where you'll never swim.

The scope of this activity might also surprise you. Over half of all trades are done by Wall Street insiders using quick-fire trading systems; 7% of all trading is done inside secretive dark pools. "The public is getting screwed here," says one hedge fund manager who follows these developments closely.

Even if you're not trying to be an active trader, these high-tech gunslingers impact the stocks you own and the mutual funds in your 401k. And, of course, we all get hurt if their rapid-fire trading systems spark a quick sector or market meltdown -– a real possibility, according to several analysts.

Here's a look at just three of the tech tricks that make life tougher than ever for the average investor.

1. High-frequency trading

In high-frequency trading, or HFT, computers use sophisticated algorithms to hunt down opportunities all but invisible to the average investor. They spot a fleeting price or complex combination of trades, then lock in gains with a series of moves made at a clip that only a high-speed computer could pull off.

The race for speed is incredibly serious. Investment shops like Goldman Sachs compete to place their trading computers as close as physically possible to stock-exchange computers to make trades an instant faster.

Video on MSN Money

The firestorm over flash trading © CNBC
The firestorm over flash trading
Steve Pearlstein of The Washington Post, CNBC's Bob Pisani and Michelle Caruso-Cabrera discuss whether high-frequency trading is bad for the markets.

HFT systems make tiny amounts of money per trade, so they have to do millions of trades to earn big bucks. It can seem like a good thing because HFT theoretically exploits only "inefficiencies" in the market -- and no one likes inefficiencies.

Besides Goldman, Citadel and Renaissance, smaller shops like Getco, Jane Street Capital, Hudson River Trading, Wolverine Trading and Jump Trading also play this game. None of them cater to the average investor. Mutual funds and money managers investing for the long term, on the other hand, don't generally use HFT because they typically have to stay in the market while building -- or moving out of -- positions. HFT trading systems generally unwind positions so they have no market exposure by the end of the day.

Continued: How it hurts the little guy

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