Thursday, July 30, 2009
This isn't your father's program trading.
Years ago, computerized trading helped eliminate inefficiencies in the market. For example, when the S&P futures contract would trade at too large a premium to the cash index, computers were programmed to buy S&P 500 stocks and sell futures contracts. These buy programs brought the premium back into line.
Likewise, when stock futures traded at too large a discount, computers would buy the futures contracts and sell S&P 500 stocks. The excessive discount would disappear, efficiency returned to the market, and Wall Street firms utilizing the strategy earned a nice profit.
It was a win-win situation.
Today, however, computers are being used to manipulate stock prices. And they're stealing your money in the process. The strategy is called high-frequency trading (HFT), and here's how it works...
Let's say ABC shares are trading at $10. A mutual-fund manager then enters an order to buy 20,000 shares. Knowing his order is large enough to affect the price of ABC stock, the mutual-fund manager places a price limit of $10.10 on his order. In other words, he's willing to pay up to $10.10 to get all 20,000 shares.
His order goes into the system. But before it is seen by you, me, or the vast majority of market participants, it is shared with a select group of HFT computers. The firms that run these computers pay an extra fee to have the orders routed to them first. Some 30 milliseconds later, about the time it takes to blink an eye, the order is displayed to everyone.
So far, there's nothing wrong. Brokerage firms are allowed to route customer orders anywhere they see fit, and institutions are allowed to pay for order flow. It is, however, what happens during that blink of an eye that concerns me. It is stock-price manipulation at best, and outright thievery at worst...
Knowing the willingness of the mutual-fund manager to buy ABC up to $10.10, and having a 0.03-second head start, HFT computers begin buying as much ABC stock as they can below the customer's limit price. They'll buy everything they can get at $10.01, then $10.02, $10.03, and so on. Once they've purchased 20,000 shares – and let's say their final purchase price was $10.04 – they instantly turn around and sell the stock to the mutual-fund manager at $10.05.
The computer turned a profit of between $0.01 and $0.04 on 20,000 shares in the blink of an eye.
"So, what's wrong with that?" you might ask. After all, the manager bought the shares below what he was willing to pay.
The problem is the manager should have been able to buy all the shares the computer snapped up between $10.01 and $10.04. The computer only bought the stock because it knew the manager was willing to pay more. And the computer knew it could unload the shares at a higher price for a guaranteed profit.
This is called front-running. It creates artificial demand for shares, and it's illegal.
Last year, HFT accounted for 15%-20% of the volume on the stock exchanges. In a survey conducted by Tabb Group, a Wall Street research firm, as much as 70% of the recent daily activity is attributed to HFT.
It's no longer computers trading with institutions. We've now entered the second generation of HFT. It's computers trading with computers.
Think about it this way...
You program your computer the old-fashioned way. You're willing to buy stocks if the S&P futures hit a certain premium to the cash index, and you're willing to sell stocks if the futures fall to a significant discount.
I know your trading parameters, and I see your orders before anyone else. So I program my computer to jump in front of your trades, thereby preventing the market from reaching the extremes at which you're willing to buy or sell, and then forcing you to chase a position. Or in a low-volume environment, I allow you to get into position then use my bankroll to pressure prices against you. I run your stop orders and force you out of position and then let the natural forces of the market run the other way.
This is what created the remarkable one-way action to the downside we saw back in March. And it's what is happening to the upside right now.
The natural ebb and flow of the market is changing. It's no longer two steps forward then one step back. It's more like 100 steps forward then 20 steps back, or 100 steps back then 20 steps forward.
In other words, thanks to HFT, the trading ranges are extended.
Regulators are now looking into ways to reduce the effects of HFT. But they're so far behind the curve, any new laws they come up with will be antiquated before they're passed. No one should rely on the folks in Washington to act on their behalf.
Instead, if you know you're playing in a rigged game, your job is to bet on the side of the riggers.
Next week, I'll tell you how to do that. It's a matter of adaptation... and it's easier than you think.
Best regards and good trading,
Oil down huge yesterday... biggest one-day drop (6%) since April.
Auto sector showing life... Ford, AutoNation, and AutoCredit make 52-week highs.
Chico's, Carter's, Ross Stores hit new highs... retail fund (RTH) at 9-month high.