Who knew about the electronic trading hubs? I certainly didn’t. And I’m sure most average investors didn’t know about them either. So it’s good to know that we’re getting screwed by the high-frequency trading process.
Loren Steffy, a Houston Chronicle business writer, wrote an easy to understand column explaining how these trades impact the stock market, investment banks and investors.
STOCK MARKET HIJACKED
By Loren Steffy
Houston Chronicle
May 12, 2010
We don't have a stock market anymore. We have a mathematical exercise gone berserk.
Last week was marked by some of the most dramatic volatility since traders first assembled under the buttonwood tree in Lower Manhattan in 1792. On Thursday, with markets already roiled by the threat of the burgeoning Greek debt crisis, the Dow Jones industrial average plunged almost 1,000 points, the largest point drop ever, then surged about 650 points, all in less than half an hour.
Don't blame the Greeks. Blame the geeks.
Regulators don't know what sparked the sell-off, but it's pretty clear what happened as the selling frenzy took hold. The New York Stock Exchange and Nasdaq slowed trading in hopes of stanching the plunge. That forced hundreds of thousands of sell orders onto electronic trading hubs, where computers make split-second trades based on pre-arranged programs. As the sell orders flooded the hubs, it triggered automatic stop losses, essentially more sell orders, and an electronic avalanche ensued. There weren't enough bids, or buyers, to offset the sales.
BIG FLOW THROUGH HUBS
These days, hubs are where most of the market action is. Only about 20 percent of the volume of NYSE-listed stocks actually trade on the exchange, down from almost 80 percent five years ago. The rest of the volume has moved to the hubs.
The exchanges canceled trades deemed erroneous in the last 20 minutes of Thursday's session. If the 1,000 point drop had stuck, the market would have lost almost $1 trillion in value within minutes.
“The lunatics completely took over the asylum,” said John Olson, chief investment officer for Houston-based Sanders Morris Harris. “The traditional meaning of a market has been lost — that is to determine some value for a stock or bond. People are trading for the sake of trading, and there is no underlying meaning to all of this.”
The Securities and Exchange Commission, once again, was caught flat-footed. It's now investigating last week's activity, and it's gotten the heads of some of the largest hubs to agree to uniform rules, such as “circuit breakers” that would halt trading sooner.
Even so, there's little incentive to rein in computer trading. Exchanges make big fees from the higher volumes that computer trading generates.
HIGH-FREQUENCY TRADING
This type of buying and selling, which I wrote about late last year, is known as high-frequency trading. Computer algorithms exploit market movements, often trading ahead of average investors to make a few pennies on each trade.
Let's say you want to buy a share of stock for $25. If the trade ultimately passes through a firm like Goldman Sachs, which has made billions on its proprietary trading business lately, your trade has to wait. Knowing that you're willing to buy at $25, Goldman's computers shoot out buy orders until it finds a seller at $24.95. Then it turns around and sells the stock to you at $25, collecting a quick nickel.
Done thousands of times a day, the nickels add up to billions over the course of a year.
‘A NUMBERS GAME’
The mathematicians and physicists writing these programs don't care about stocks' underlying value. Earnings, management, sales — nothing investors typically evaluate — matters. The computer programs look for things that might affect stock prices — the potential effect of a small movement in crude futures on Exxon Mobil, for example — then shoot out hundreds of buy or sell orders in milliseconds until they get a hit.
“There's no idea of buy and hold anymore,” Olson said. “If all you have is computers looking for tiny price differentials, then this just becomes a numbers game.”
THIS IS A MARKET?
It's a hugely profitable business, but it's not what those traders gathered under the buttonwood tree envisioned when they set up what became the NYSE to determine the value of stocks.
They created a market. What we have today is more like a giant roulette wheel.
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