Computer
Trading Dominates All Financial Markets -- "Investment" Obsolete
By The Curmudgeon
High-frequency-trading (HFT), quote stuffing, derivatives and
the "carry-trade" are now dominating global stock (and
other financial) markets. The big trading firms don't even remember the
old boring ways of buying and selling stocks. In fact, the revered
specialist system on the NY Stock Exchange is gone- replaced by computers
trading with one another. It has been said that 60- 70% of NYSE volume
comes from HFT. And you wonder why even short term trends don't persist?
HFT Explained: HFT computers apparently use algorithms
to fade the short term reaction of professional traders. When the news is
bad and the market is down, the HFT computers kick in and buy at the same
time, squeezing the shorts who had sold earlier. One computer can
enter 10,000-20,000 orders in one second. It overwhelms those who are on the
other side of the trades.
Illustration of HFT based on fast keyword search: News
feeds, such as Dow Jones, Bloomberg and Reuters are input directly
into HFT computers. The algorithms recognize keywords, such as
"big upside earnings surprise for xyz" or "xyz misses
estimate by 3 cents per share." That triggers the computer
program to place up to 10,000 individual orders in 1 second. Multiply
that by a number of different computers from different HFT firms, and you can
see the potentially huge influx of orders, literally in a few milliseconds.
A specific HFT example: On Aug. 4, Priceline announced
earnings that were much better than expected. The stock soared over $50 per
share in a matter of seconds. Obviously, human beings wouldn't want to pay
$50 per share more only 1 second after an earnings announcement. And they can't
place the orders that quickly. But computers trading with other computers can
do it.
There are other algorithms used by HFT firms- all of
them proprietary. If you look at the websites for financial jobs, you will
see many ads for computer programmers and mathematicians to work in HFT
operations.
"Quote stuffing" is a newer method of the
HFTs. Here is a report from a trader:
"...a
war between HFT ‘bots’ and their firms. It is bot vs.
bot as HFT computers battle each other for short-term
profits. The newest technique, and one that may have caused the May Flash
Crash, is called quote stuffing."
Quote stuffing first came to light in a report by Nanex, one of the leading market trading analytics firms,
in a report about the Flash Crash. In this report, Nanex
presented irrefutable evidence of quote stuffing by HFT algorithms in tens of
stocks in which thousands of canceled quotes would reappear each second with
regularity right around the time of the May "Flash Crash." It is
ILLEGAL to indicate a quote without a trade intent, but according to Nanex, it was happening at an alarming rate.
Worse, Nanex concluded that this
type of quote stuffing is in fact manipulative and can end up "pushing
bid/offer range up to 10% HIGHER without even one trade ever having
occurred." This is blatant upside market manipulation, and to make matters
worse, the SEC has looked the other way (even though reports blame quote
stuffing for the Flash Crash in May).
The exchanges and regulators won't officially address the
potentially illegal situation in order to avoid scaring investors away, and
they don't want the exchanges to lose this lucrative business. Here is
a new article that highlights the dangers:
Implications and Conclusions:
Has anyone noticed that all the market rallies, however
sharp, are on very low volume? And that the volume on the NYSE far
exceeds that of the NASDAQ- the reverse of the last 12 years? That is
because the public and conventional institutions are either out of the market
or sitting on their hands. It's also likely that computers trading with
other computers get better execution (tighter bid-ask spreads) on the NYSE vs.
NASDAQ and that individual NYSE stocks have larger share floats and
trading volumes.
The computers are dominating trading, without human
intervention. And the algorithms used or so short term in nature, that
they blow out the quants who have intermediate term
trading models.
HFT and other computerized trading is why all the
fundamentals--discussed endlessly by the financial media are now irrelevant. Take
technical trading systems based on trend following (price/volume),
support/resistance, breakouts/breakdowns, moving averages, stochastics,
etc don't count anymore either. Each time the S & P 500 has a
good rally it is smashed down and each time it breaks down it rallies back to
the last resistance (in this case 1100 - the last rally failure) and sometimes
exceeds it by one or two percent. But that doesn't change the direction
of the market, which is back and forth with a downward bias.
But the worst part of all this computerized trading is that
the SEC and other government regulators are turning a blind eye to it.
They seem to be oblivious to HFT, quote
stuffing (see Thurs Sept 2 WSJ lead article+), and other front
running computerized schemes. They refuse to investigate on the terms
that all these HFTs are providing needed liquidity to the market, and there has
been no formal request by the exchanges to investigate this matter. This
may now change as reports are swirling that Quote Stuffing caused the May Flash
Crash.
+The WSJ reported, "The Securities and Exchange
Commission has begun looking into whether the practice is putting some
investors at a disadvantage by distorting stock prices, according to people
familiar with the matter. The SEC is looking at what role, if any, quote stuffing
played in the May 6 "flash crash," when the Dow Jones Industrial
Average collapsed 700 points in minutes, the people say."
http://online.wsj.com/article/SB10001424052748703882304575465990082237642.html
In the meantime, here is a message for all those long and
short term traders: Caveat emptor!
The Curmudgeon
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.