The "Myth of Latency Arbitrage"? If You Believe That Expect To Be Taken By The Market's Flash Traders.

Author Michael Lewis ('Flash Boys') described in detail back in 2014 how flash traders- using the high frequency trading (HFT) gambit are able to see milliseconds ahead of your buy orders to get there before you can, buy the stock and raise the price.  In a way it's  kind of tax on your transactions, so you don't come out as far ahead as you thought. Also, the same applies to sell orders. They can get there first, and you get much less than you originally thought you would.

Lewis - in connection with a book tour- emphasized the flash traders often traded on fractional share values but these inevitably pile up. Billions could be made off the backs of poor ordinary day traders, who trusted that when they placed their buy or sell orders no shenanigans or secret advantages were afoot. But alas, this isn't the case. It only takes a tiny fraction of a second of a flash trader's advantage (i.e.  a delay or "latency" for you)  for them to see slightly ahead - to what you're intention is - and do it before you do.

Now we learn ('High Speeds Seen Increasing Costs Of Stock Trading', WSJ, Jan. 28, p. B1) we're expected to believe that "latency arbitrage" (the process by which HFT greases the stocks wheels for the few) is a "myth" and circulated for political reasons.  This put forward by Kirsten Wegner quoted in the piece who is an HFT specialist with Modern Market Initiatives - a bunch that promotes flash trades.

Here's the skinny you ought to know (ibid.):

"High frequency traders earn nearly $5 billion a year by taking advantage of slightly out of date prices, imposing a small but significant tax on ordinary investors."

This according to a new study by the UK's  main regulator, the Financial Conduct Authority (FCA).   The practice goes by the name "latency arbitrage".

"Latency" meaning the delay in time - often fractions of a second (hardly "out of date" as the WSJ describes it) so that the HFT guy can gain an advantage - enough so that by the time the ordinary run of the mill investor buys or sells it's already at markedly lower prices.  In other words, if you also don't use HFT you lose.  (Though one professor cited from the Univ. of Chicago's Booth School Of Business claims that the losses imposed for ordinary households are minor. )

He also says the HFT set already have to pay higher costs on their trades.  Well, yeah, ok, but those losses may add up to a few hundred million bucks while they're still raking in over $4 billion extra a year off the hides of ordinary blokes..

But this is why politicians in both the U.S. and Europe - including Senators Bernie Sanders and Elizabeth Warren are pushing for a financial transaction tax, "a policy aimed in part at curbing high speed trading".

The tax will be only a few cents on each dollar traded but because the HFT can do thousands of transactions per second, the  tax hit on them will clearly be bigger than for the small fry ordinary investors- who may make only one 'call in' or online trade a day - or per hour at most.

All of which shows the experts cited in the piece who say  "latency arbitrage raises costs for (ordinary) investors  by making everyone in the markets less likely to post competitive price quotes for stocks" is correct.   I mean why would you willingly lowball yourself if some HFT hotshot is getting ready to rip you off using fast trades?  I.e.

Why do so,  "knowing that those quotes will get picked off  by the fast frequency trades."

Proving again the stock market is a rigged game unless one has the same 'weapons'  or systems as the high frequency traders.  Or plenty of disposable income to be able to afford the inherent disadvantages over time.

Do Americans Really Deserve The Mockery of the Money Men For Avoiding Stocks?

In a recent issue of MONEY magazine (September, p. 16) millennials and other demographics  were raked over the coals for their aversion to the stock market, say keeping their savings in cash instead of the stock market. The piece noted:

"Across all age groups only 16 percent said the stock market was the best place to keep money long term, despite its higher returns."

The short article goes on to single out millennials especially given 32 percent of them say cash is a superior investment to stocks.  Then adds: "If you had invested $10,000 in the Vanguard 500 stock index 10 years ago you'd have $20, 940 today."

But comments like these are easy to make with 20-20 hindsight and not knowing what events may lie ahead.  For example, what happens if a guy has been investing for some 25 years and just as he retires and needs that money  - which hitherto had been on paper- the market craps out? Well, depending on how severe the downturn he may be out of luck and have to live very frugally - even if not going back to work to try to recoup his losses. The wise guys at MONEY never tell you that part.

Or other aspect of the investment game.

Let's take the case of new investors rushing into Company "XYZ" which goes public and issues 10 million shares of stock to 2 million people, for $50 a share. The market capitalization here is therefore $500 million. This total capitalization is what determines payouts in the end. Say, for example, the original stock share plummets after ten years to 50 cents a share. The market capitalization has now decreased a factor of 100 ($50/ $0.5 = 100) to $5 million. If there are no 10 million investors, the share price can be no more than 50 cents a share and that is the maximal cashout (redemption) amount. Thus if all ten million stock holders cash out at once they will (theoretically) get 50 cents a share.

But since stock managers do demand  expenses, commissions, etc. the actual payout may be a lot less. Thus, what theoretically might look like 50 cents per share on paper, for an actual mass redemption, will really end up as probably only ten cents per share.  Think this is a nutso example? I have news for you! Back in 2011 according to The Financial Times yesterday, Marley Coffee had a share valuation of $6.50 (each). Two days ago it was down to 1 cent.

While all this is dreary news for stock pumpers, we haven't even gotten to taxes yet. Most people are abysmally ignorant in terms of the returns after taxes. In fact, given recent high share prices as indicated by the price to earnings (or P/E ) ratios,  a typical stock fund investor must wait an average of 28 years to double his profits, with taxes and expenses taken into account.

How badly do taxes eat up returns? Stock guru  John C. Bogle once provided an estimate ('Fund Fees Are Beyond Excessive', Mutual Funds, 10/ 98, p. 80: "In a normal environment, stocks give 10% nominal annual returns, but after incomes taxes, and after inflation, investors might get real returns of 5%. "   And we haven't even factored in commissions, other expenses yet!

A Stanford University study- based on the median return of 62 mutual funds- showed that $1 invested in 1962 would have grown to $21.89 by 1992, on a pre-tax basis. The study disclosed that the $1 would have grown to only $9.87 on an after-tax basis. And the investor would have had to come up with $12.02 to pay the taxes.   By contrast the study showed that a “conservative” investor who put assets into a U.S. Savings Bond in 1962, had every $1 become $10.93 by 1992.

Of course in today's low yield, zero interest rate (effectively) environment, most finance mavens such as run MONEY will regard anyone who goes for savings bonds today a dunderhead. But are they really?

Let us recognize that the market is already in asset bubble territory. Arch-forecaster Nate Silver, in his book, The Signal and the Noise- Why So Many Predictions Fail But Some Don’t  warns (p. 347):

"Of the eight times in which the S&P 500 has increased at a rate much faster than its historical average over a 5-year period , five cases were followed by a severe and notorious crash, such as the Great Depression and the Black Monday crash of 1987”.

Interestingly, two of the largest stock market dives have followed two of the biggest bubbles: the first of 37.85 percent and on the heels of the bubble that formed from Jan. 14, 2000 to Oct. 9, 2002, and the second of 58.78 percent that formed (mainly due to the housing bubble) from Oct. 9, 2007 to March 9, 2009.

Another warning alarm is traced to higher share prices arising from company stock buybacks, which really amounts to a form of liquidation (which I will elaborate on soon). WHY would a company need to buy back its own stock to create an artificial rise in share price if the company is genuinely doing well? It makes no sense. If a sound going to use any extra money for anything it ought to be for paying dividends, not stock buybacks!

But stock buybacks have been "going through the roof" lately.  A recent NY Times piece ('The Buyback Illusion.', Aug. 14, Business, p. 1) noted they are more often "a way for executives to make a company's earnings per share look better because the purchases reduce the amount of stock it has outstanding"  Also, "when per share earnings are a sizable component of executive pay the motivation to do buybacks only increases."  The problem is that ultimately this game amounts to a "liquidation program". In the scheme of reinvestment one has buyback in which a "shrunken pie is divided among fewer people" and actual reinvestment which "grows a bigger pie" via affirmative moves that benefit Main Street not just Wall Street..

Why aren't the little guys more aware of how they're being shafted? Maybe for the same reason, as former trader Michael Lewis has observed ('Flash Boys') , they're not paying attention to how flash trading is ripping them off via "millisecond" advantage and thereby gaining pennies on the dollar with each trade made. They essentially gain those pennies (which add up to billions over time) by getting shares redeemed before you can via that slight micro-time advantage.

Readers may recall high frequency trading (HFT) first came to light in the May 6, 2010  “flash crash” of over 500 points. This event brutally demonstrated the perils of so –called “flash trading”. Then we first learned of the high speed computers which use special algorithms to detect large buy and sell orders then adjust their trades to take advantage. Since the high speed computers can 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.

But we're still not done in terms of running the numbers of potential stock or mutual fund losses. To get down to cases, a stock – or mutual fund- that drops in share price from $20 to $10 has suffered a 50% loss. But for that $10 stock or fund share price to return to $20 it must gain 100%, or double. This may take not just two or three years, but more than TWENTY!

Many people who risk money in the markets do not  know that if a share of anything goes down by 20%, it requires an advance of 25% to get back just to the breakeven point. If the value of a share drops 40 percent (as has occurred with some recent mutual fund hits since 2013), you'd need a 66.7 % advance to break even. If the share drops 50% - as already noted- a 100% gain must be registered to return to ‘break-even’ (i.e. you’re not losing more than what you already paid).

Here's the deal: I don't care what your returns or share prices show on paper. That is just phantom money.  Phantom money is not real, spendable money until it is redeemed.  Until then you can't build a secure income stream around it because it's variable. - from day to day and week to week as the markets gyrate over every little thing.  The problem is that the odds of getting a clean redemption, i.e.maxing out your returns just when you want them, are less than 1/2 day out of 365  (or about 1.3 in 1,000)  according to the author of 'Surviving the Coming Mutual Fund Crisis'.   He notes that only 5 % of mutual fund holders manage to redeem their shares in time to reap maximal returns.

Michael Lewis, author of The Big Short, has noted the stock market  is "built on quicksand, and people who invest in stocks are not paying serious attention to the underlying fundamentals."  Instead they're being mesmerized by flickering numbers on crawl screens, and carried away by temporarily inflated share prices and think this will net them compile a hearty retirement nest egg.

Lastly, one of the most enlightening articles that ever appeared in The Wall Street Journal, had to be from Nov. 27, 2003, page D1, 'A Harsh Truth: Most of Your Investments Won't Make Money- Even in the Long Term.

That was the precise and exact header from the article, a copy of which I preserved.

The article noted what I have numerous times, that taxes (capital gains), fees, commissions and other expenses will essentially eat up any gains from most investments. And that is in a GOOD YEAR! Over time, even a long haul, the average gains are barely over 2% when taxes and expenses have been deducted.

Are the millennials dummies then for avoiding the stock market? Maybe not as much as the mavens at MONEY magazine believe. Of course, when I use the term "cash" I do not mean that literally as in stashing it in mattresses. I mean in terms of income, over speculative instruments. I.e. money market accounts, CDs or other safe income investments.

If, however, a person - millennial or other - comes into a windfall and can afford to part with a hundred thou in a loss without wasting time making it up, I say 'go for it'.  Make wise choices and perhaps pick an index fund but don't interact too much.  But if you  don't have the money to lose, never mind the green eyeshade types - you're best in conservative instruments. This is especially if - like Joseph Berardino warned in an FT piece some years back -the current reporting system “fails to communicate essential information about the real risks facing companies” to the small investor.

Berardino warned that accountants can only issue ‘pass’ or ‘fail’ judgments on companies – but cannot disclose the red ink being bled by a company that’s been passed. (What's referred to as a “bleeding edge” company wherein auditors are actually resigning). To do so would precipitate a collapse in share prices.  Who gets stuck by this 'black hole' of information? Why the little guy investor, of course, aka Joe Schmoe.  Under such conditions, the small investor risks his money and security, by investing in ANY non-FDIC insured monetary device.

A word to the wise: DO what feels right for YOU. Just be sure you're not just stashing cash in a mattress.

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Update:   As per a report in today's Denver Post Business Section (p. 15A) a participant in a Morgan Stanley 401k filed a lawsuit Friday against MS for "millions of dollars in losses" suffered by nearly 60,000 participants. Morgan Stanley was blamed for a plethora of fund offerings "with poor track records and high fees".

Losing in the Stock Market? Blame the Flash Traders for Wall Street Being RIGGED!

High frequency traders plan their next move - to see the 'buy' orders of millions a fraction of a second before they can be placed.

Author Michael Lewis ('Flash Boys') described in detail this morning (CBS Early Show) how flash traders- using the high frequency trading (HFT) gambit are able to see milliseconds ahead of your buy orders to get there before you can, buy the stock and raise the price - so you don't come out as far ahead as you thought. Also, the same applies to sell orders. They can get there first, and you get much less than you originally thought you would.

Lewis, who originally appeared on '60 Minutes' last night, emphasized the flash traders often trade on fractional share values but these pile up. Billions can be made off the backs of poor ordinary suckers, who trust that when they place buy or sell orders no shenanigans or secret advantages are afoot. But alas, this isn't the case. It only takes a tiny fraction of a second of flash trader advantage for them to see slightly ahead - to what you're intention is - and doing it before you do.

Incredibly, none of this seems to be illegal,  though New York AG Eric Schneiderman said this morning (on the same Early Show) that:

"There are two things we have to do. One is to investigate the Commodities Futures Trading Organization, and the SEC has to investigate whether there's anything currently illegal and second, we have to inquire whether this requires new laws and reforms to catch up with technology".

Which means that in the meantime the ordinary investor is a sitting duck, at the mercy of these high frequency traders and their flash trade computer algorithms.

Readers may recall HFT first came to light in the May 6, 2010  “flash crash” of over 500 points. This event brutally demonstrated the perils of so –called “flash trading”. Then we first learned of the high speed computers which use special algorithms to detect large buy and sell orders then adjust their trades to take advantage. Since the high speed computers can 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, mutual fund or stock hyping, and misrepresentations, e.g. of "5 year annualized returns".

For example, the 5 -year annualized return (without dividends) at the end of 2012 showed negative 0.6 percent. But at the end of 2013 it showed 15.4 percent, and you'd have been kicking yourself for not being in the market. But hold strain! The reason for the difference is that for the latter 5- year stats the dismal 2008 stats were entirely wiped off the books from the standpoint of the "five year return", especially the S&P 38.5 percent drop without dividends.

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 accounted for two-thirds of total stock market volume. All other things being equal, that meant unless one had access to a flash trade system or algorithm himself, he had a 2 in 3 chance of being victimized by flash trades, if even peripherally. Today, some four years later, that HFT volume exceeds  90% and the little guy is in a perilous position unless he also has access to such trades. In most cases, as AG Schneiderman observes, it is large institutional investors who use them to gain advantage for their members.

Let’s look at one example of how HFT works. Say a flash trade system or firm, using its high frequency computer, detects a large buy order for a stock listed initially at $20 a share. Then - with milliseconds advantage - 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 before you can buy it. The large (institutional) investors then buy it at the lower price, and the flash firm makes a killing,  while the ordinary  "Joe Schmoe"  loses out, paying more.

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. This may well be why mutual funds are being decimated as reported in MONEY magazine ('Mutual Funds Gone Down the Drain', March, p. 19).  According to the piece, citing a Morningstar report: "of all the traditional funds operating a decade ago, 4 in 10 shut down before 2014."

Why should you care? As the article notes:

"Even though you can cash out, costs rise and performance falls as the end nears."

This is all the more reason flash trading needs to be brought under control. Readers who seek to lean more should get hold of Michael Lewis' book, 'Flash Boys'.