Monday, May 24, 2010

Shooting Dirty Pool

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 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.

Friday, May 21, 2010

Casino Boogie

When you are short the market and get a 10% correction from the April 23rd highs, it can really put steam in a man's stride, especially when you are leveraged like I am. However, here's the rub: I began adding short positions to my portfolio in April of 2009, taking a sizable paper loss. I didn't go in all at once, but my investing acumen as well as my patience have surely been tested. Just doing back of the envelope calculations, I figure I need the DOW to get back to 8,000 before I start playing with the house's money. You may think I look like a sucker ready to be fleeced, but I'm not going to welsh on my bets. I did my homework and followed my instincts and, when I first went short the S&P 500, I thought it was the right thing to do. In hindsight, I should have waited, but at the time I made my initial investment, I thought I was fine-tuning my portfolio to make a significant amount of money and I still do. I didn't play this fast and lose like many of these fly-by-night traders do, just following the hot money on a second-by-second basis. I've always been an investor, looking at the long-term picture, and what I see isn't pretty.

The market is cooling down after burning it to the wick for over a year. This is a fast-buck business and some of the indices like the S&P 500 have broken through their 200 day moving averages. This may not seem like a significant event to many retail investors, but it is. A daisy chain of mainframe computers are programmed to either sell or buy once an index hits a dynamic predetermined level like a moving average. This may have been what caused the "flash crash" on May 6th, and although the market isn't falling off a cliff today like it did in October 1987, it may have triggered a downward spiral that will last awhile. Star-studded panels of investment gurus will grace the television screens and the business newspapers about what will happen next, but they don't know any better than you or I do. If there is one thing I've learned about investing after 20 years of following the market religiously, it's that you're out on your own.

I've got a dim notion of what to do right now - just sit tight. It's the best thing I can come up with after getting humbled the past 12 months. Let's not forget that we've been down this road before in re to 10% corrections since the market lows in early March of 2009. This may be it and we'll get another pop to the upside. I don't want to be the boy who called wolf, so I'm not going to tell you that we are going to get a 20% or 30% correction or retest the lows or blast right through that resistance level. I've done that before and it will get you nowhere, especially since I've made my investing views public. What I will say is that the mission creep in the worldwide financial sector has gotten way out of control and sovereign debt crisis seems to be permeating the conversation both domestically and over in Europe. For the mean time, I'll keep a poker face and just watch things unfold.