Stock market trading costs have fallen tremendously in the past 25 years, despite concerns that high frequency traders (HFTs) take unfair advantage of average investors. The benefits of innovation have been huge, so saying that HFTs are hurting you is like whining that Santa brought you a Bentley instead of a Rolls Royce.

The average bid-ask spread dropped sharply in the 1990s according to research by Charles M. Jones. (The bid-ask spread is the difference between the price bid by a buyer and price asked for from a seller.) His chart showing average bid-ask spreads on stocks in the Dow Jones Industrials is reproduced below (with his kind permission). So my great grandfather, had he traded stocks in 1900, would have faced a 70 basis point (hundredths of one percent) spread between the offer to sell and the offer to buy. By 2000, I faced a 20 basis point spread.  Jones finds a similar pattern looking at all New York Stock Exchange stocks and examining transactions costs, adding half the bid-ask spread plus commission. (The NYSE data is only available starting in the 1920s.)

Although this data set goes only to 2000, the drop in spreads from 1993 through 2002 was documented in a paper by James Angel, Lawrence Harris and Chester Spatt. A slightly different analysis of more recent data, also by Jones with Terrence Hendershott and Albert Menkveld, found that from 2001 through 2006, spreads fell from about 20 basis points to five basis points. All told, spreads have dropped more than 90 percent.

Several factors have driven spreads down. Decimalization helped. That was the Securities and Exchange Commission requirement in 2001 that stock exchanges stop using fractions (like 1/16^th) and switch to decimals (like 0.06).

Trading volume has increased substantially, as Angel, Harris and Spatt documented, and higher volume usually allows lower spreads.

Electronic quotation and trading also helped, as spreads do longer must support human traders setting bid and ask prices.

Stocks used to trade on just one exchange, but now there are a myriad of exchanges competing with one another for investors’ favor.

High frequency trading (HFT) has also brought improved liquidity into the market, as the paper by Angel, Harris and Spatt showed. (The algorithmic trading described in that paper differed from current high frequency trading in speed of execution and holding periods, but not in basic character.)

Here’s the common sense explanation. A stock like General Electric has average daily trading volume of 33 million shares, compared to 8.85 billion shares outstanding. Suppose that a mutual fund places an order to sell one million shares. That order is large compared to the number of shares available to buy or sell at any one moment, but it’s small compared to the 8.85 billion shares outstanding. The price will fall temporarily but settle back after the order has been digested. The old market makers would protect themselves from this risk by quoting a wide spread between bid and ask. Now HFTs, if they are good, will see the price decline as temporary, buy at the low price, then sell when the market has settled down. Stock prices fluctuate less, and at any given moment the bid-ask spread is narrower, thanks to the HFTs.

Could HFTs destabilize the market, by selling when the price is down, further depressing it? That’s certainty a possibility, but Milton Friedman argued that if speculation is profitable, it stabilizes markets, as speculators buy when the price is low and sell when the price is high. The profitability of HFTs proves their stabilizing effects, though there can be exceptional times.

The Michael Lewis bestseller Flash Boys presented stories in which brokers colluded with HFTs to take advantage of investors. Lewis’s examples typically showed investors bearing an extra cost of a penny or two per share. Fraudulent action certainly deserves punishment, but let’s keep this in perspective. Trading costs are very, very small relative to where they used to be. HFTs have helped drive costs down, though plenty of other factors have also been at work. (See my article Flash Boys And High Frequency Trading: Trust Markets, Not Regulators.)

Worrying about a penny or two seems trivial when I used to gripe about a quarter-point bid-ask spread. Like an old Texas oilman once said to me, “Don’t be crying with a ham on your shoulder.”