You can feel the populist rage against the machines of Wall Street and Washington these days and rightfully so. Taxes are going up and 401Ks are going down, sometimes faster than expected like on May 6th when the "flash crash" occurred. Big drops in the market scare people, especially when it leads on the evening news. Originally dubbed the "fat finger trade" because the speculation was that somebody on a trading desk put in an order to sell billions of dollars work of Proctor and Gamble (PG) stock instead of millions of dollars. That theory has been ousted for the belief that flash trading was the culprit. The terms flash trading and high-frequency trading have been bandied about ever since the May 6th drop and not to be confused, flash trading is a form of high-frequency trading and an examination of the two is warranted.
A great many Main Street investors think that your run-of-the-mill pikers on day trading desks can move the market up or down 1,000 points in the bat of an eye, but that's a modern myth. High-frequency trading now moves the market because according to Wikipedia "it now accounts for 73% of U.S. equity trade, although the firms involved constitute only 2% of trading firms.". Day traders have nothing to do with high-frequency trading. They don't have the computer power to be in the mix. Investopedia gives a definition: "High-frequency trading is an automated trading platform used by large investment banks, hedge funds and institutional investors which utilizes powerful computers to transact a large number of orders at extremely high speeds. These high frequency trading platforms allow traders to execute millions of orders and scan multiple markets and exchanges in a matter of seconds, thus giving the institutions that use the platforms a huge advantage in the open market.".
I've got no beef with high-frequency trading. It's a natural evolution of the use of computers in the stock market. It's a very clever idea invented by a clever man by the name of Ed Thorp who is the godfather of all quants. Back in the 1960's he wrote the seminal high-frequency trading book Beat the Market: A Scientific Stock Market System where he discussed the use of mainframe computers in taking advantage of the anomalies of the inefficiencies in the market. Arbitrage is another word for this. What I object to is a subset of high-frequency trading called flash trading, hence the term "flash crash" coined to describe the events on May 6th.
Again, our friends at Wikipedia will provide us with a quick definition: "Flash trading is a controversial practice of some financial exchanges whereby certain customers are allowed to see incoming orders to buy or sell securities earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. With this very slight advance notice of market conditions, traders with access to extremely powerful computers can conduct rapid statistical analysis of the changing market state and carry out high-frequency trading ahead of the public market.". As you can see, Wall Street insiders get the inside tract as to where the market heading. I know life is not fair at times, but this is way out of whack in terms of the game according to Hoyle. It's not a level playing field for the small investor. Now you may be wondering how flash trades can take place when there is regulation by the FED. The answer is that they trade in dark pools which are unregulated.
Venkatachalam Shunmugam posted a recent blog on voxeu.org which discusses dark pools and states: "Dark pools are a private or alternative trading system that allows participants to transact without displaying quotes publicly. Orders are anonymously matched and not reported to any entity, even the regulators. Thus, the mainstream exchange-traded market does not have any clue about the volume of transactions happening in this parallel market or the prices at which they are being executed.". In other words, not only does the little guy have an unfair disadvantage, but so does a lot of the smart money. "According to the Securities and Exchange Commission, the number of active dark pools dealing in stocks on major US stock markets trebled to 29 in 2009 from about 10 in 2002. For April to June 2009, the total dark pools volume was about 7.2% of the total volumes of all US exchanges.", Shunmugam informs us earlier in his post. As we can surmise, flash trading is just getting more popular, which does nothing for market stability. There is nothing cooking in Washington in the near term future to regulate these dark pools. Expect more market volatility and large, unexpected moves to the downside until the playing field is leveled.