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Computer Trading Dominates All Financial Markets -- "Investment" Obsolete

By The Curmudgeon

Sept. 4, 2010

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:

http://www.dailyfinance.com/story/investing/another-suspect-in-the-flash-crash-quote-stuffing/19619124/

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.