Low-Frequency Trading System Provides an Edge Over Day Trading and Buy and Hold

Fifty years ago, General Electric (NYSE: GE) traded at $73.37 a share, according to the historical data. But, it didn't really trade that way. Fifty years ago, traders used fractions and GE would have been quoted at something like $73 3/8 bid, $73 1/2 ask. The ticker tape back then showed the prices in fractions and trade confirmation statements that came in the mail for every single buy and sell also showed the fractions.

The difference between the bid and ask prices, known as "the spread," was usually the market maker's profit on a trade. Market makers were the people on the exchange floor who executed the orders. They maintained inventory of a stock and were obligated by exchange rules to maintain a market in a stock under any conditions. Market makers were forced to buy in market crashes and they were sellers in bubbles, but they were typically pocketing 12.5 cents per share on many of the trades they made. This could be a lucrative business even when volume was low.

In March 1963, volume in GE averaged 1.4 million shares a day, with market makers potentially earning about $175,000 a day if they made 1/8 of a dollar on every share.

Quotes shifted away from fractions in 2001, and market makers began disappearing from exchange floors shortly after that. Markets still needed someone to take the opposite side of a trade whenever an individual investor wants to buy or sell, and high-frequency trading (HFT) firms have at least partially stepped into that role.

The difference between the bid and ask prices in GE is now 1 cent most of the time, but the average daily trading volume of more than 38 million shares like we saw in the past 30 days allows for substantial profits of more than $380,000 a day if firms are able to capture the difference in the spread on every trade.

HFT firms are in some ways a reinvention of the market makers and they helped lower the cost of trading for individuals who now enjoy penny spreads on many stocks. To provide this service, they need complex computer algorithms and access to real-time market data. HFT computer systems in some cases are located as close to the exchange servers as possible and connected with gold-plated cables to minimize delays in data transmission. They execute trades in milliseconds, but HFT firms are making very small amounts of money on each trade.

Individuals can't compete with HFT firms and they shouldn't try. HFT firms may try to earn profits of less than a penny a share on their trades. Individuals should target the higher profits that come from long-term trends.

Testing shows longer holding periods can be better. Using a simple trading system based on Moving Average Convergence/Divergence (MACD), traders can beat buy and hold and reduce risk with daily and weekly data while they'd show steep losses trading intraday. This system buys when the familiar MACD histogram is positive and moves to cash when it is in negative territory.

MACD Trading System Results

Results based on SPDR S&P 500 (NYSE: SPY) from Jan. 1, 2007, through Feb. 28, 2013. Assumes a trading cost of 2% per trade and ignores dividends.

This demonstrates the idea that individuals can be winners if they take advantage of the trading edge they have. Day trading means competing against HFT firms with better access to data and more advanced computer systems. As these firms focus on short-term profits, individuals should look at the long term where they can benefit from trends.

Applying simple trading rules can beat a buy-and-hold strategy without much work. Individuals could look at their favorite indicator daily or weekly and follow the signals. It might be surprising to some to see that low-frequency trading can be simple and profitable for anyone following a trading system with discipline.

Action to take: Consider looking at trading signals generated on a weekly basis to manage long-term investments like retirement accounts.

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