Weekend Market Commentary: Special Edition

Written by Gary

Weekend Market Commentary: What Is High Frequency Trading And Should We Be Concerned?

UPDATED: 0900 EST 2014-08-02

Last week I wrote about one of the low-life aspects of the market and today I write about another; High frequency Trading (HFT). I can not see where these ‘SkyNet’ like computers contribute to the well being of the retail market. These HFT algo computers that skew the open retail market is where 9 out of 10 investors are going to loose, said Sriram Srinivasan.

If every trade was taxed, the HFT algorithmic (algo) computers would come to a grinding halt. If unethical practices were heavily penalized instead of a wink and nod from the SEC, we might start to have a decent market place that would no longer be call a casino along with snide remarks about the crooked financiers behind the black curtain blowing smoke up our arse.

According to John Shmuel, “Lehman’s fall caused markets to dry up, which is why some exchanges, such as the New York Stock Exchange, subsequently courted high-frequency trading firms with incentives to use their exchanges. The NYSE calls this its supplemental liquidity providers program.” That is what the proponents of HFT say anyway.

In his article, The good and bad of high-frequency trading, is really more about being educated and knowing what is going on out there. Investor education is all well and good, but it doesn’t stop or hinder the HFT practice which hurts most investors, especially human traders.

. . . market volatility today is near record lows (the short-term VIX index, a measure of volatility, dropped to its lowest level ever earlier this year) even though high-frequency trading is more dominant than ever.

One of the issues that does come out is the lack of volatility . . . They’re telling me the lack of volatility is a bad thing because there aren’t the kind of trading opportunities that there used to be before.

Charles Schwab calls HFT like it is, ‘I is a growing cancer’.

HFT Is A Growing Cancer by Charles Schwab via Schwab

High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets.

It’s a growing cancer and needs to be addressed. If confidence erodes further, the fuel of our free-enterprise system, capital formation, is at risk. We can’t allow that to happen.

For sure, we still believe investing in equities is a primary path to long-term wealth creation, and we believe in the long-term structural integrity of the markets to deliver that over time for individual investors, which is all the more reason to be vigilant in removing anything that creates unfair advantage or undermines investor confidence.

HFT according to Wikipedia is a type of algorithmic trading, specifically the use of sophisticated technological tools and computer algorithms to rapidly trade securities.

High-frequency trading (HFT): HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second. Firms such as British-based Algorates, one of the first to employ HFT, rely on advanced computer systems and the processing speed of their trades to record high earnings in the market.

It is estimated that as of 2009, HFT accounted for 60-73% of all US equity trading volume, with that number falling to approximately 50% in 2012.

High-frequency traders move in and out of short-term positions aiming to capture sometimes just a fraction of a cent in profit on every trade.[2] HFT firms do not employ significant leverage, accumulate positions or hold their portfolios overnight.

As a result, HFT has a potential Sharpe ratio (a measure of risk and reward) thousands of times higher than traditional buy-and-hold strategies.[11] High-frequency traders typically compete against other HFTs, rather than long-term investors. HFT firms make up the low margins with incredible high volumes of tradings, frequently numbering in the millions.

The Dark Side Of High Frequency Trading, says BuySideTimes.com is not very good and the HFT practice effects every investor and trader one way or another. Here are some of the practices that can happen in milliseconds.

Quote stuffing is the entry of numerous orders without legitimate commercial reasons to create uncertainty for other market participants. It is a strictly prohibited to enter an enormous number of bids and offers in a security, outside the current spread to create “noise” in the quote feed. Essentially, that gives the “quote stuffer” an opportunity to arbitrage the price differential market centers as other trading participants process the noise.

Layering is a trading activity where orders are placed at or away from the current levels to create the appearance of a change in supply and demand. This artificially moves the price of the security and the trader then executes an order on the opposite side of the market and then rapidly removes the first.

Momentum ignition, also called “pump and dump” involves the placing of multiple high speed orders with no legitimate price driving event which initiates a trading trend. The trader intends to get others to follow, thereby allowing an opportunity to unwind a position at an artificial price level.

Ping orders are the entry of small orders to trigger a reaction by other participants to gain information about positions. This can include entry, deletion and amendment of orders with low resting time and no legitimate commercial reasons.

Wash trades are a trade or series of trades with no economic justification in order to give the impression of brisk activity or movement in price. This can be done by buying and selling the same exact security with two different brokers to create the illusion of activity but with no market risk or economic impact to the traders’ positions.

Ian Fraser via Qfinance says:

Not only is HFT legalized front-running. It is also a socially worthless activity that amplifies market movements, increases market fragility, inflates asset price bubbles, and naturally worsens market crashes.

And as we saw with the ‘Flash Crash’ of May 2010, it can also fuel market mayhem.

Tens of thousands HFT that can alter market trends in a millisecond and there isn’t chance in hell you, the retail investor, can catch it. I personally watched the ‘Flash Crash’ on May 6, 2010 and it was all over by the time I realized what had happened. The Dow Jones Industrial Average plunged about 1000 points (about 9%) only to recover those losses within minutes all because one trader initiated a very large sell order as a hedge to an existing equity position. (Detail Story here.)

Now these HFT are dealing in the Dark Pools discussed last week as well.

Dark Pool Disfavor Above 50% in Poll Amid High-Frequency Fallout

Dark pools and high-frequency traders, two elements of the electronic U.S. stock market whose rise has been decried in books and Congress, are finding little support among financial professionals.

At least half the respondents in the Bloomberg Global Poll professed a negative view of the anonymous equity markets and proprietary firms that buy and sell stocks in millionths of a second.

“I don’t like secret societies,” said Peter Nielsen, a senior investment analyst and poll respondent at Saturna Capital Corp. in Bellingham, Washington, which oversees $4 billion. “I don’t like secret trading; it just runs against my personal disposition,” he added. “I’m a big believer in transparency — huge believer in transparency. Even the word ‘dark pool’ freaks me out.”

Hazel Henderson, in her book review of ‘Dark Pools’ By Scott Patterson, says “it is a page-turning, fascinating account of how computerized algorithmic high-frequency trading (HFT) and electronic platforms evolved, took over financial markets and turned the NYSE floor into a mere “puppet-show for TV.”

One commenter even remarked, “I think the short version of this is that trained computer monkeys can and will make mistakes, and they will be big ones.”

How could so many computer geniuses like Peterffy, Joshua Levine, the brain behind Island, Jerry Putnam, founder of Archipeligo – all trying to democratize Wall Street, have been so blind to the unintended consequences?

The genie was out of the bottle. Applying computer power to Wall Street was a lucrative “no-brainer,” as well as a dream of a few to make markets more efficient, transparent and cheaper by displacing the middlemen: the specialists and old market-makers. Misguided academics, physicists and quants flocked to hedge funds lured by the big bucks.

We all know the tragic results and await the next Flash Crash, global in scale, some call the Splash Crash caused by interlinked trading centers at warp speeds juggling every kind of security (beyond quaint risk-management concepts like diversification, Value-at-Risk, models, in “a worldwide, push-button money grid”).

The Mathematical Investor writes about the book, ‘Dark Pools’, “Readers also learn about the early software that these pioneers wrote, which gave them the edge in their trading: Levine’s “Watcher” program, which permitted users to monitor literally hundreds of stocks or securities; the Datek “Monster Key,” which permitted Datek traders to jump to the top of the queue and thus outmaneuver competing traders; and Tradebot, one of the first fully algorithmic trading programs.” None of this is any good or helpful to retail traders as it only produces loser’s.

In closing, Michael Lewis’s complaint is that, “if there weren’t any algobots at all, then those profits would have gone to real-money investors, rather than high-frequency traders, and that the algorithms are taking advantage of unfair levels of market access to rip off the rest of the participants in the stock market.

Felix Salmon summarizes, “. . . the net effect of the algorithms is negative: they reduce profits, for everybody, rather than increasing them.”

Like last week, the bottom line concerning Dark Pools was that you are screwed; this week you got it again! But that is OK, because the SEC has been doing something about algo HFT – and like last week summery, it is all smoke and mirrors. You know that anything the SEC says they are doing something for you is pure BS, piled high and smelly.

The solution is really simple, tax every trade and heavily penalize any quote stuffing or unethical practices. What do you think?

(Follow Closing Market Averages at end of this article)

WTI oil closed Friday at 97.62 (down -0.39 -0.39% )

Brent oil closed Friday at 104.66 (down -0.39 -0.37% )

The Demon The Gold Bears Are Mistakenly Overlooking

Gold closed Friday at 1294.30 (up +4.00 +0.31% )

Copper closed Friday at 3.219 (down -0.001 -0.02% )

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Friday’s Closing Market Numbers

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Written by Gary