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Trading at the speed of light - Will the US senate act?

by The Wrinkle | May 28, 2010

Well it looks like the tide might be coming back in across the financial markets, as the volatility subsides along with the fear and panic. A broker recently commented that investors were behaving like “a cat with a long tail in a room full of rocking chairs”. Assuming stability does return it will be up to investors to “lick their wounds” and count the damage.

Over the last few weeks I’ve been “rabbiting” on about trading volumes, churn, high-frequency traders, micro-second trades and the multiplier effect this causes in global stock markets, and in particular the US markets which are arguably the de-facto bellweather for global financial health. This week I might have one last play in this “sandbox” and then leave it alone for now.

In 1955 around 10% of all US stocks were held by institutional investors, currently these professional (for want of a better word) traders and investors hold around 60% of all US stocks. (Source: Federal Reserve Flow of Funds, thanks to Alan Kohler who has a nice graph of this in his Eureka Report).

Obviously the inverse of this is that in 1955 “value” and by their nature longer term individual investors held 90% of all US stocks. Today less than 40% of stocks are held by value or individual investors, and the trend has pretty much been consistently heading the same way ever since 1955. Taking this trend to its unnatural conclusion, will the last individual “value” investor in 2055 please turn off the lights on the way out and leave all trading to the machines.

If you are an individual investor the simple fact is that you are now in the minority and your voice is generally becoming quieter, not louder. There is a very good recent article in the New York Times on this issue following what is now called the “flash crash” in US Markets on May 6th.

I’ve put together the following “sound bites” from the article to give an overview of what is being talked about here, the quotes and facts to a large extent mirror what I’ve been talking about previously and I’ll let them speak for themselves.

Inside the humdrum offices of a tiny trading firm called Tradeworx workers…typically buy and sell 80 million shares a day.

But on the afternoon of May 6, as the stock market began to plunge in the “flash crash,” someone here walked up to one of those computers and typed the command HF STOP: sell everything, and shutdown.

Across the country, several of Tradeworx’s counterparts did the same. In a blink, some of the most powerful players in the stock market today — high-frequency traders — went dark. The result sent chills through the financial world.

After the brief 1,000-point plunge in the stock market that day, the growing role of high-frequency traders in the nation’s financial markets is drawing new scrutiny.

Over the last decade, these high-tech operators have become …a shadow Wall Street.

Depending on whose estimates you believe, high-frequency traders account for 40 to 70 percent of all trading on every stock market in the country.

Some of the biggest players trade more than a billion shares a day. (Wrinkle – note this is some of the 100 to 200 players, not a total).

These are short-term bets. Very short. The founder of Tradebot, told students in 2008 that his firm typically held stocks for 11 seconds.

Tradebot, one of the biggest high-frequency traders around, had not had a losing day in four years, he said.

While market regulators are still trying to figure out what happened on May 6, the decision of high-frequency traders to withdraw from the marketplace is under examination. Did their decision create a market vacuum that caused prices to plunge even faster

(Wrinkle - People regularly trading billions of shares a day suddenly withdraw from the market and there’s no vacuum, confusion, or panic. Hello)

“We don’t know, but isn’t that the point? How are we ever going to find out what’s going on with these high-frequency traders? Whenever you have a lot of money, a lot of change, little or no transparency, and therefore, no regulation, you have the potential for a market disaster,” said Senator Edward E. Kaufman.

“The market structure has morphed from one that was equitable and fair to one where those who get the greatest perks, who have the speed, have all of the advantages,” said Sal Arnuk, who runs an equity trading firm in New Jersey.

The high-frequency club consisting of 100 to 200 firms are scattered far from the canyons of Wall Street. Most use their founders’ money to trade. A handful are run from spare bedrooms, while others, like GetCo in Chicago, have hundreds of employees

(Wrinkle – of course these high-frequency trading firms also exist in Australia, one I’ve heard of was set up by an Aussie ex-pat who had previously worked for a similar company in the Netherlands, they had a staff of over 30 several years ago and were very profitable)

Their profits come in slivers of a penny, but they can reap those incremental rewards over and over, all day long.

(Wrinkle – Just like watching a washing machine go round and round and round, as boring as bat guano, but a very nice little earner)

What all high-frequency traders love is volatility — lots of it.

“It was like shooting fish in the barrel in 2008. Any dummy who tried to do a high-frequency strategy back then could make money,” said Manoj Narang, the founder of Tradeworx.

The Tradeworx computers get price quotes from the exchanges, decide how to trade, complete a risk analysis and generate a buy or sell order — in 20 microseconds.

The computers trade in and out of individual stocks, indexes and exchange traded funds, or E.T.F.’s, all day long. Mr. Narang, for the most part, has no idea which stocks Tradeworx is buying or selling.

If high-frequency traders crave volatility, why did Tradeworx and others turn off their computers on May 6? Mr. Narang said Tradeworx could not tell whether something was wrong with the data feeds from the exchanges.

More important, Mr. Narang worried that if some trades were canceled — as, indeed, many were — Tradeworx might be left holding stocks it did not want.

And there in lies the rub, these traders aren’t interested in holding stocks or taking positions, they make their money on churning stocks. Being a split second faster than the next guy to pick and see a trend. How this contributes to the real economy or society is a question for us all. To those who argue it creates liquidity, better markets etc I would argue that the markets were fine until this practice first appeared and some say contributed to the 1987 market crash.

Ultimately history tells us that the laws of economics will prevail over time, whenever there are super profits to be made the space will become increasingly crowded until profits are reduced to more realistic rates of return. How far do you have to go to beat the next smartest trader with the latest technology? How about the speed of light.

“New software by startup company ALGO Technologies offers to cut trade execution time to levels close to the speed of light, giving exchange clients an edge in the high-frequency trading arms race.

The system takes 16 microseconds, or millionths of a second, per round-trip for a trade from outside an exchange's firewall, compared with 250 microseconds on Nasdaq OMX, 270 microseconds on BATS Europe and 400 microseconds on Chi-X Europe, according to measurements by independent firm Corvil, based on volumes of 300,000 messages per second.”

Quote – International Business Times – 19 April 2010 (no longer available)

As more and more people climb into this space, can we look forward to trillions rather than billions of trades a day.

Now tell me the world isn’t going to hell in a handbasket. Remind me again, why do we need this?

As for the real world impact of all this volatility and drama, let’s have a look at my first stock pick in this blog as an example. GGP is a junior onshore US oil producer and explorer, so it’s effectively an oil play with potential upside from exploration “wins”. In early May the oil price was around USD 82 a barrel, with a USD/AUD exchange rate of 92.5 cents, today the oil price is around USD 75 a barrel and the exchange rate is around 85 cents. In AUD dollar terms during May the oil price has moved from $88.60 to $88.20, or hardly at all.

Accordingly from an economic perspective the value of the company is pretty much the same; however the share price has moved from 3.3c to 2.5c a drop of 24%. On 3rd May a potential script based takeover of another private company was announced, but this was canned a week ago. Presumably this was due to the share price and currency movements. This is a real life example of the sort of impact volatility can have in the real world, the company is still doing what it’s always done and it’s prospects haven’t changed.

As for GGP, I still think it’s a good buy and slightly increased my holding to 550,000 shares. The next month will be a bit of a “coin toss” as the major players square off their books for the end of the tax year. However I expect this stock to still grow strongly post 1 July as its drilling programs come online.

Still time (or at least the illusion of time) seems to cure all, if for no other reason than giving us a wider perspective. On that philosophical note, next week we will venture into a much wider perspective and a longer time horizon. We talked earlier (albeit tongue in cheek) about the demise of the value investor over 100 years. Next week we will carry the 100 year timeline forward, George Friedman’s book on geopolitics’ “The Next 100 Years” makes very interesting reading and signals the rise of three nations who might surprise you.

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