Monday, September 24, 2012

The Computer: Investment Tool Or Time Bomb (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

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.

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