One of our central beliefs here at Notes is that the game of investing is rigged. And it’s rigged against you, dear reader.

A recent investigation by traders Sal Arnuk and Joseph Saluzzi of Themis Trading reveals that up to 70% of volume in US equity markets is currently being generated by what are known to Wall Street insiders as “high frequency traders” (HFTs).

What are HFTs and why you should be concerned about their dominance in the markets right now will be the subject of today’s Notes. We’d put it to you this way. HFTs are like the robot Arnold Schwarzenegger plays in the Terminator movies. They’re built for one purpose only: to annihilate anything that stands in their way. And right now, that means you.

First, what are HFTs? Here’s how Arnuk and Saluzzi define HFTs in their excellent white paper “Why Institutional Investors Should be Concerned About High Frequency Traders” :

HFTs are computerized trading programs that make money two ways, in general. They offer bids in such a way so as to make tiny amounts of money from per share liquidity rebates provided by the exchanges. Or they make tiny per share long or short profits. While this might sound like small change, HFTs collectively execute billions of shares a day, making it an extremely profitable business.

Second, why should you care? Again, we turn here to the wise words of Themis’s Arnuk and Saluzzi:

1. Volume has exploded, particularly in NYSE stocks. But you can’t look at NYSE volume on the NYSE. The NYSE only executes 25% of the volume in NYSE stocks. You’ve got to look at NYSE listed shares across all market centers, such as ECNs, like the NYSE’s own ARCA, or dark pools, like LiquidNet. Traders Magazine estimates high frequency traders may account for more than half the volume on all U.S. market centers.

2. The number of quote changes has exploded. The reason is high frequency traders searching for hidden liquidity. Some estimates are that these traders enter anywhere from several hundred to one million orders for every 100 trades they actually execute. This has significantly raised the bar for all firms on Wall Street to invest in the computers, storage and routing to handle all the message traffic.

3. NYSE specialists no longer provide price stability. With the advent NYSE Hybrid, specialist market share has dropped from 80% to 25%. With specialists out of the way, the floodgates have been opened to high frequency traders who find it easier to make money with more liquid listed shares.

4. Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year. According to recent findings by Goldman Sachs, spreads on S&P 500 stocks have doubled in October 2008 as compared to earlier in the year. Spreads in Russell 2000 stocks have tripled and quoted depth has been cut in half.

5. High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

We fully realize that these concepts are difficult to grasp. And many of you may be sorely tempted to shut down this email and move on to something easier to digest. That’s fine. We make no apologies for tackling complex issues here at Notes that you won’t find discussed in the mainstream financial press.

But readers who stick with us will begin to grasp what not one investor in a thousand understands: that the stock market is not made up of humans but of highly sophisticated machines and that every time you buy or sell a stock you are going up against these machines. Worse: this new generation of highly profitable, high-speed computerized trading methods are causing investors to chase artificial prices.

That’s because many of these HFTs are predatory. That is they are designed to trigger other HFTs to pile into a trade and thus lock in artificially high (or low) prices This, again, from Saluzzi and Arnuk:

More than half of all institutional algo orders are “pegged” to the National Best Bid or Offer (NBBO). The problem is, if one trader jumps ahead of another in price, it can cause a second trader to go along side of the first one. Very quickly, every algo trading order in a given stock is following each other up or down (or down and up), creating huge, whip like price movements on relatively little volume.

This has led to the development of predatory algo trading strategies. These strategies are designed to cause institutional algo orders to buy or sell shares at prices higher or lower than where the stock had been trading, creating a situation where the predatory algo can lock in a profit from the artificial increase or decrease in the price.

So where does this leave you as an individual player in the market? Unfortunately, there is very little individual players can do for now, other than be aware of the situation. Understanding the rules of the game is critical to your success as an investor. And right now, the rules are changing rapidly.

We have fired off an email about this critical issue to Simon Mellon of Bonner & Partners Family Office, veteran crisis investor James Dale Davidson and quant expert Charles Delvalle (who heads up Payout Trader, an investment service with a ridiculous 100% success rate so far). We know these guys personally. They’re some of the smartest guys in the market. Hopefully, they will have advice for Notes readers on how to deal with the growing HFT threat. Watch this space…