| Defining "Risk" in Two Words: Wall Street |
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| Thursday, 01 October 2009 00:17 | |
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As we've pointed out in our book,The Big Gamble, there really is no such thing as an investment; it's all speculation. We've also gone into detail on the subject of risk; what it is, it's various forms, and how to measure it in terms of the potential payoff. Well, here's a little something else you should consider about risk so you know exactly what you're up against. When technology is involved, the odds are definitely not in your favor. Do you know why there has been such a sharp increase in trading volume lately? It’s because of something called "automated high-frequency trading." These computerized trades can take advantage of minuscule price changes that are too fleeting for mere mortals to catch—such as a tiny flash-in-the-pan increase in the spread between bid and ask prices on a particular stock. From his computer, an alert broker can hit a home run with a quick keystroke. Trading happens so fast that some firms have actually relocated their computer servers closer to the exchange's computers so they can shave a nano-second off the distance that the electronic order has to travel through the wires. This kind of trading is now as wide spread as it is fast. By some estimates, high-speed computer trades account for 60 to 70 percent of all U.S. stock trades made by investment banks, hedge funds and other high rollers. The naysayers claim that electronic trading bears closer scrutiny because it could be manipulating the markets, or worse, may spark the next financial crisis. Some believe that computer-based trading caused the meltdown of '87 when things got out so of control so fast, more than 22 percent of the value of US stocks was wiped out largely during the first hour of trading. And nobody knew how to pull the plug. But the yaysayers claim that lightening-speed trades are a good thing—they improve liquidity, reduce trading costs, and keep the wheels of the market slicked. More about that in a minute. Regulators aren't exactly sure what to think, but they are keeping an eye out for any mischief making related to exotic Wall Street products and strategies. For instance, they spotted a red flag this summer with "flash orders," a form of high-frequency trading that takes advantage of regulatory loopholes. Flash orders gave certain traders a heads up about orders just a fraction of a second before the information was transmitted to the rest of the trading world. Let's say a broker gets an order to buy a stock for up to $20 a share. So he buys the shares at the market price of $19.75 but sells them to the customer at $20, thereby duping the customer out of 25 cents per share. Factor in the concept of flash trading and the broker has the same power, only now it all happens a whole lot faster and with more frequency. Fortunately, as of last month, the SEC has proposed a ban against this practice and condemned it as a form of illegal front running. We all know that every trade represents a gainer and a loser and we can safely assume that high-frequency traders are the more savvy of traders and therefore have an unfair advantage. Consider that some of these movers and shakers participated in the 2008 profits of upwards of $21 billion. If high-frequency traders are making billions, is someone else – like you – losing money? Are those profits coming out of your pocket? Perhaps if you have a long-term buy-and-hold strategy, you don't have to worry much about high-frequency trading profits. After all, those billions of profits represent small amounts multiplied and spread over millions of trades. (By the way, don't pat yourself on back about that buy and hold strategy just yet—in case you haven't noticed, even that one hasn't held up in today's economy.) Now, to all the yaysayers out there who claim that high-frequency trading expands market liquidity, may we remind you that some attempts to expand liquidity have just paved the way for out of control speculation and frenzy. If enough traders leaped on the same factors of a certain stock, such as a fractional price dip, and if everybody else followed suit, the results could end up like a lot of other herd mentality scenarios. Pick up a copy of our book, The Big Gamble, and flip to chapter five entitled, Booms Busts, and the Herd Mentality. You'll find plenty of examples of the chaos that ensued from that kind of bandwagon madness. We agree that high-frequency trading needs closer scrutiny from the SEC. One wonders if all these profits are a result of market manipulation or due to the improvements in market function that this kind of trading produced. We'll let the SEC find out and tell us. Then again, we have recently discovered that the SEC is not as proficient as we all once believed. Bottom line: Know the risks and what you're up against before you put your money into the market! |
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