Monday, September 24, 2012

The Computer: Investment Tool Or Time Bomb (2)


We will continue our look at the use of computers on Wall Street.  A new form of computer trading started several years ago, and some of its more spectacular effects have been reported in the financial press.  There are firms, referred to as high frequency traders (HFT), which program their computers with complicated algorithms to identify small profit opportunities in the market.  These traders make thousands of trades in rapid succession within seconds.  Some trades are completed and others are cancelled.  Although the actual profit per trade is small, the huge volume of trading can result in overall gains.  It has been reported that, in the past, as much as two-thirds of daily  trading volume on some stock, options and futures exchanges is the result of the computer trading programs employed by such firms.   Much of this trading occurs on electronic trading exchanges, which are separate from the more established exchanges used by individual investors and their brokers, but trades on one exchange are monitored by traders on all exchanges and can have an effect on prices on other exchanges.

Although the true causes may never be agreed upon, the HFT firms are alleged to have played a role in the May 6, 2010 Flash Crash, during which the Dow Jones Industrial Average fell almost 1,000 points and then recovered most of that decline in a matter of minutes.  A joint report by the US Securities and Exchange Commission and the Commodity Futures Trading Commission, agencies which investigated the event, indicated that May 6th was "unusually turbulent" with a widely negative trend.  In the afternoon, a mutual fund was trying to sell a large number of S&P 500 futures contracts to hedge its other equity positions.  Several HFT traders began buying them and then quickly reselling them to other HFT firms.  This buying and selling picked up steam, resulting in what was termed a "hot potato" effect on exceptionally large volume.  The result of this repeated back and forth trading sent the price of the particular contract down 4% in about four minutes.  This precipitous drop spilled over into the equity markets and the price of an S&P 500 exchange traded fund also plunged.  The New York Times reported that, "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling."  The Times went on to state that, as traders moved to the sidelines (which meant there were no buyers), this, "caused shares of some prominent companies like Proctor & Gamble and Accenture to trade down as low as a penny or as high as $100,000."

All of the volume and price changes triggered a 5 second pause in the trading of the S&P 500 futures contracts on the Chicago Mercantile Exchange.  This short break in the action allowed the markets to stabilize and once the computers were stopped and human decisions again played a role, the prices of most assets recovered almost completely.

The Flash Crash is one example of computers run amok affecting the entire market.  Sometimes the damage is isolated and wreaks havoc only on the HFT running the computer program.  The poster child for this sort of self inflicted financial wound is Knight Capital Group.  Knight Capital is a Wall Street trading firm which on August 1, 2012 was rolling out a new computer program designed to give it an advantage in the world of HFT traders.  The new software started at the opening of the New York Stock Exchange and, in the 45 minutes before the NYSE closed down Knight's trading, resulted in trades that ultimately cost Knight Capital approximately $440 Million in losses.  On that Wednesday, the stock of publicly traded Knight Capital Group dropped 32%.  The stock continued to fall the next day, ultimately closing down that day 63%.  Without a quick bailout from other Wall Street firms, the company would have ended up in bankruptcy.  All of this damage was caused by a bug in the new software, which obviously had not been tested enough before being put into action.

As you can well imagine, this form of trading has come under a great deal of scrutiny by regulators.  In addition, many Wall Street professionals are beginning to criticize HFT as providing an unfair advantage over less computer reliant market participants.  Here is a link to a very enlightening article in the New York Times on HFT traders and their critics.

We will look at one more example of computer investing gone awry in the next blog.

Comments are always welcome.

Monday, September 17, 2012

The Computer: Investment Tool Or Time Bomb (1)


In a recent blog, we followed a trading strategy which was attributed to Jesse Livermore, the famous trader of the 1920s.  Back then, Livermore's tools consisted of the telephone and the ticker tape which allowed him to follow the changes in price with the shortest delay.  In today's fast paced trading, most on Wall Street use computers to initiate, follow and close out their trades.  This is the case regardless of the assets being traded, be they stocks, bonds, options, futures, currencies or commodities. 

Many professionals use their computers for more than just tracking their trades.  They also use computer programs to run trades.  At the same time they are buying a stock, some individual investors and traders will instruct their broker or program their computer to sell the stock if the price drops by a preset amount (say 5% of the purchase price).  This instruction is called a stop loss order.  The stop loss order can also be used to lock in a gain.  If the stock has increased in price, the individual may, at any time, set a price below the current market price at which the stock is to be sold, thereby locking in the amount of gain the person is hoping to make without having to constantly monitor the market.  As the price increases, the stop loss order price can be raised.  This is one fairly basic strategy which can be initiated from the individual's computer (or with a phone call to the broker).  On its face, this sounds like a smart, conservative approach to investing and trading.  The individual has quantified and limited any loss, while letting any profits run.  If used on a grand scale, however, unintended consequences can result.

In his book, Irrational Exuberance, Professor Robert J. Shiller recounts the results of the Brady Commission's report on the October 1987 market crash.  The Commission was established by President Ronald Reagan to find out what caused the Dow Jones Average to drop 508 points (22.6%) on October 19, 1987.  The Commission reported the following:

The precipitous market decline of mid-October was "triggered" by specific events: an unexpectedly high merchandise trade deficit which pushed interest rates to new high levels, and proposed tax legislation which led to the collapse of stocks of a number of takeover candidates.  This initial decline ignited mechanical, price-insensitive selling by a number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions.  The selling by these investors, and the prospect of further selling by them, encouraged a number of aggressive trading-oriented institutions to sell in anticipation of further market declines.  These institutions included, in addition to hedge funds, a small number of pension and endowment funds, money management firms and investment banking houses.  This selling, in turn, stimulated further reactive selling by portfolio insurers and mutual funds. (underline emphasis is mine)

Professor Shiller summarized this as follows:

By "price-insensitive selling" they mean selling that comes in response to a price drop but is insensitive to how low the price goes before the sale is concluded -- selling at any price.  The commission was saying here, most prominently, that the crash was caused by what I have called a feedback loop, with initial price declines influencing more investors to exit the market, thereby creating further price declines.  The Brady Commission was saying, in effect, that the crash of 1987 was a negative bubble.

Portfolio insurance was the marketing term for a computer program which instructed the investors' computers to sell stocks when they had declined by a certain amount, in effect, a stop loss order.  The problem was that many different computers' selling programs kicked in at the same time leading to ever lower prices and repeated sell orders, over and over, in October, 1987.  This appears remarkably similar to the avalanche of margin calls leading to ever lower prices and repeated margin calls, over and over, in October, 1929.  Blind reliance on a computer program to replace human decision making can result in widespread losses for the entire market.  The investment holdings of millions of individual investors were decimated with those of the Wall Street giants relying on portfolio insurance to protect their positions in 1987.

We will look at other computer generated problems in the next blog.

Excerpts from Shiller, Robert J.; Irrational Exuberance, copyright 2000 Robert J. Shiller, published by Princeton University Press, reprinted by permission of Princeton University Press.

Comments are always welcome.

Monday, September 10, 2012

Living On The Margin (3)


Al Frank, in his book Al Frank's New Prudent Speculator, said that he used margin in his investing.  He did acknowledge its dangers, especially in a market decline:

There is no free lunch on Wall Street.  Well, hardly any.  Margined or leveraged stock results cut two ways.  Just a 25 percent increase in the market price of a portfolio yields a 50 percent increase in its equity -- at the 50 percent margined level -- so a 25 percent decline in market price would result in a 50 percent decline in equity at the same margined level.  This leverage can lead to even greater destruction on rare occasions such as the Crash of October '87 or the Selloff of '90.*

Shorting a stock is, essentially, the same use of margin in reverse.  Jesse Livermore made millions shorting stocks during market crashes.  I must assume that there were short sellers during the '87 and '90 drops mentioned by Mr. Frank, but their gains were far outstripped by the losses incurred by millions of others in the market during those dark days.

Frank said that he would heed margin calls and sell enough of his equity to maintain his margin positions if he felt strongly about his strategy with a stock.  Humphrey B. Neill held the opposite position.  In his book, Tape Reading & Market Tactics, he advised his readers as follows:

The Market Philosopher's advice to his class is: never answer a margin-call.  Tell your broker to sell enough of the shares he is holding for you to meet his requirements.  The margin-clerk is your best friend: he can be depended upon to tell you when to sell; and if you do not follow his tip, he will sell anyway.

In order to check up on this theory of its being best never to answer a margin-call, I once interviewed a number of brokers.  They all, without exception, told me that traders would fare much more profitably than they usually do, if they never replied with more money to protect their margin accounts.

And why should they not?

Your judgment is bound to be biased when your stocks are going against you.  It is impossible for you to consider all factors calmly.  When you purchased your stocks you expected them to advance.  If the opposite movement occurs, your judgment is wrong.  Then why, in Heaven's name, throw good money after bad?  What is the difference, after all, between a paper loss and an actual loss?  Your equity is exactly the same on the broker's book (minus the selling commissions).  You are no better off, holding on, than you are if you sell out -- in fact , you are not as well situated, because more of your capital is tied up; thus you weaken your position, possibly to the point where you cannot take advantage of whatever bargain prices there may turn up later.**

(Author's emphasis in bold)

As with every other investment strategy we have looked at, it all comes down to what makes the most sense to you as an individual investor.  If you feel comfortable using margin, then do so.  If it seems too dangerous for you, then don't.  Being a successful investor or trader on Wall Street requires that you have full confidence in your method of investing.  If you decide to invest on the margin, I suggest you take Neill's advice to heart and never return that call from your broker.

*  The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

**  Excerpt from Tape Reading & Market Tactics, Humphrey B. Neill, republished by BN Publishing, pages 213-214.

Comments are always welcome.

Monday, September 3, 2012

Living On The Margin (2)


In the last blog on margin loans, I gave a simple explanation of the process.  You may remember earlier blogs about Jesse Livermore, the famous 1920's trader who made and lost millions trading on margin.  Edwin Lefevre's thinly disguised book about Livermore, Reminiscences of a Stock Operator, included the following lesson on margin trading:

People don't seem to grasp easily the fundamentals of stock trading.  I have often said that to buy on a rising market is the most comfortable way of buying stocks.  Now, the point is not so much to buy as cheap as possible or go short at top prices, but to buy or sell at the right time.

Let us suppose, for example, that I am buying some stock.  I'll buy two thousand shares at 110.  If the stock goes up to 111 after I buy it I am, at least temporarily, right in my operation, because it is a point higher; it shows me a profit.  Well, because I am right I go in and buy another two thousand shares.  If the market is still rising I buy a third lot of two thousand shares.  Say the price goes to 114.  I think it is enough for the time being.  I now have a trading basis to work from.  I am long six thousand shares at an average of 111 3/4, and the stock is selling at 114.  I won't buy any more just then.  I wait and see.  I figure that at some stage of the rise there is going to be a reaction (he means a price drop).  I want to see how the market takes care of itself after that reaction.  It will probably react (he means a price rise) to where I got my third lot.  Say that after going higher it falls back to 112 1/4 and then rallies.  Well, just as it goes back to 113 3/4 I  shoot an order to buy four thousand -- at the market of course.  Well, if I get that four thousand at 113 3/4, I know something is wrong and I'll give a testing order -- that is, I'll sell one thousand shares to see how the market takes it.  But suppose that of the order to buy the four thousand shares that I put in when the the price was 113 3/4 I get two thousand at 114 and five hundred at 114 1/2 and the rest on the way up so that for the last five hundred I pay 115 1/2.  Then I know I am right.  It is the way I get the four thousand shares that tells me whether I am right in buying that particular stock at that particular time -- for of course I am working on the assumption that I have checked up general conditions pretty well and they are bullish.  I never want to buy stocks too cheap or too easily.

If you take nothing else away from that passage, you should recognize that trading like this is a full time job for a professional, not an "every so often" grab for quick profits by an amateur dabbling in the market.  Benjamin Graham (I called him the Godfather of fundamental investing) was very blunt in his assessment of using margin.  He said it was not investing, it was speculating.  If you are a long term investor, you should probably stay away from margin.  If you choose to trade on margin successfully, the most difficult task you will face is convincing your spouse that you can give up your day job.

We will take a final look at margin in the next blog.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series.

Comments are always welcome.