Friday, July 2, 2010

The Flash Trade Game Continues

The May 6 “flash crash” of over 500 points on Wall Street brutally demonstrated the perils of so –called “flash trading” wherein high speed computers use special algorithms to detect large buy and sell orders to adjust their trades. Since the high speed computers can then act in nanoseconds to either buy or sell with the flash information, they inevitably get the better of the more conventional (slower) investors. The “flash crash” likely occurred because a number of flash computers processed information too quickly or inaccurately inciting a mass sell off.

What’s the little guy investor to do? Not much, and as I’ve repeatedly stated before, no little guys belong in the Wall Street scene, especially if they have lots of money (say in 401ks or IRAs) they are depending on for retirement. The reason is not just flash trading but many other gimmicks, including market timing (for which I’ve just received an invitation to participate in a class action suit for one fund – Janus Worldwide- I held in the 1990s, but dumped before it tanked), as well as burning yield, churning and collusion using ‘micro caps’ to keep clients buying and selling stocks within a closed artificial market (Source:‘License To Steal: The Secret World of Wall Street Brokers and the Systematic Plundering of the American Investor, page 211).

Also, beyond all these gimmicks and gaming, the stock market is a vast pyramid scheme. Humping assorted funds or stocks on business shows entices small folks to buy in which increases the P/E or price to earnings ratio – effectively inflating the stock price. At that point the “sharks” – usually hedge fund owners or other sly operators- cash in when the stock or fund price hits a certain threshold, taking their winnings and leaving scraps for the little guys (who, of course, are told to “buy and hold”).

Little guys can’t be blamed because usually there are no warning lights or buzzers telling them when to dump a fund or stock. (Though the WSJ noted yesterday that one marker that’s often been used is a stock index cross or “crossing” point, where the DOW and S&P500 cross over each other in a time graph. That just occurred two days ago.)

How influential is flash or high frequency trading? According to The Wall Street Journal (‘Fast Traders Face Off with Big Investors over ‘Gaming’, June 30, 2010, p. C1) it now accounts for two-thirds of total stock market volume. All other things being equal, that means unless one has access to a flash trade system or algorithm himself, he’s got a 2 in 3 chance of being victimized by flash trades, if even peripherally.

Let’s look at one example. Say a flash trade system or firm is using its high frequency computer - algorithm combo as noted earlier, and detects a large buy order for a stock listed initially at $20 a share. Then the flash trade firm will immediately begin scarfing up the stock – driving up the share price – say to $25 or $30 a share or more. The large conventional (institutional) investors then buy it at that price, and the flash firm makes a killing.

Usually the institutional investors are those who manage 401ks, for example, which means the little guy 401k owner ends up paying more in this case. (In another case, a mass flash trader selloff may see the little guy’s fund share value plummet).

Bear in mind here 401ks are typically invested in mutual funds comprised of a body of stocks, maybe ten or so. The flash traders’ capability with their high speed system is such that it can control the numbers for all the stocks of a particular fund, though true, there are some funds (e.g. Vanguard Group) which offset some of the effects by systematically lowering trading costs. This is often done by narrowing the spread between what investors pay to buy and sell shares.

Other funds don’t fare as well since the flash traders’ systems “front run” them. Thus, a stock’s orders (or many stocks in a fund) get “picked off” by the flash traders’ computers that detect the orders, then adjust to benefit. Not surprisingly, large institutional investors and consortiums are now trying to fight back with anti-gaming methods.

Others want federal regulation of high frequency trading, and Sen. Ted Kauffman (D, DE) has been a lead advocate. This has come amidst an avalanche of complaints that flash trading is tilting the field against the conventional investor, both big institutional version and the little guys. (Once charmingly referred to as "dumb order flow" by Wall Street brokers, at a particular brokerage house.)

One minor step taken by the SEC has been to unveil a plan to identify high frequency trading firms with unique identification codes to better track their activities. In the meantime, algorithms for high frequency trading are projected to account for 60% of all stock trading this year up from 28% in 2005.

On the plus side, the increased volume of flash trades has caused the stock trade volume to go down. The average size of a stock trade is now around 220 shares compared to 724 shares per trade in 2005. The net effect is it’s now more difficult for flash traders to buy large chunks of stock at once.

Of course, the high speed traders, to recover advantage, are now altering their algorithms to detect any signs of a “large chunk” trade. And the beat goes on.

My advice to those who would hold Wall Street stocks is save your money- and instead put what you can’t afford to lose in safe money fund accounts (in 401ks, IRAs), or in CDs and money market accounts. If you have some spare bucks you can afford to lose, then try the craps tables on the Las Vegas strip – you’ll do much better than on Maul Street!

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