Options and high-frequency trading

There has been much talk lately of high-frequency trading (:HFT) and what it does--or doesn't--mean to the markets and retail traders. The big issues and arguments make me more thankful than ever that I trade options.

I am not an expert on HFT and don't really want to argue semantics, but I am not especially worried about those traders picking up pennies. I am looking to make dollars, so that amount is trivial.

Moreover, the options I buy and sell usually have penny-wide bid/ask spreads, which are also made possible by cutting-edge technology. Remember, those spreads used to be a quarter wide or more, so there is clearly a benefit to retail traders.

The larger issue with HFT is the potential instability that it can cause or aggravate. "Flash Boys" author Michael Lewis, whose book has stirred the latest controversy over the practice, said in a recent interview that even if the amounts at issue in HFT are trivial, "What is not trivial is an unstable structure."

Indeed, the " flash crash " of May 2010 was not a ride that most people want to take again. And mini-crashes that occur on a regular basis continue to raise concerns because no one knows just how bad they could be.

Flash crashes are so named only because they recover. The real problem will come with a big drop that is not followed by a quick rebound.

This is one reason that makes options so appealing. Most traders understand the need to manage risk, but stop-loss orders don't work in a crash . You will almost certainly get filled at a price that is much lower than you ordered, therefore carrying much more risk than you imagine. And a flash crash is even worse, because you are likely to get filled at the lower price and sell your stock just before it rebounds.

Options obviously don't have that issue, as they are binding contracts. Owning puts against long stock protects your position, and you know exactly what your risk is.

Of course, that is essentially the same as just buying calls at the same strike, which also ties up less capital. Call spreads have even less risk and capital requirements. (See our Education section)

And while the majority of stock traders don't short positions because of the potentially unlimited risk, most option traders are comfortable buying puts. Even if the stock returns to where it started on the rebound, the puts will be worth more because of the increased volatility .

There are clearly issues with high-frequency trading that need to be worked out. I don't have any definitive answers, and no one is asking my opinion anyway. But I do have options, and they allow me to lay aside any worries to focus on trading my edge.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)

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