Download now: The Downfall of Cable, and the Rise of 5G!

High Frequency Trading

Flash Orders Come Under Fire from Capitol Hill

Written by Brian Hicks
Posted August 3, 2009

The NYSE is "not a fan" of flash orders; London exchange heads are scrutinizing them as we speak.

But most investors are still in the dark when it comes to the world of lightning-quick bulk trades.

Here's what high-frequency trading and flash orders mean to you. . .

High-Frequency Trading: Volatility in Microsecond Increments?

It's a simple fact that volatility scares investors. . . We have beta to measure a stock's movement compared to patterns in the S&P 500. People flock to safety in bonds, the dollar, and gold when seas get rough, and the Chicago Board Options Exchange has its fabled VIX volatility index to show just how off-kilter the market is at any given time.

Last autumn, the VIX was through the roof:


VIX volatility index

Volatility is, in fact, way down from autumn '08's highs, and the VIX has retreated to a channel between 20 and 30.

But it shouldn't surprise you that the government's twitchy arthritic knee is kicking out hard at volatility as it continues to react to the global financial meltdown of 2008.

The target du jour is flash orders, where computers at high-frequency trading firms can find tiny inefficiencies in the market and display bid/ask rates without executing a trade.

U.S. Senator Charles Schumer (D-NY) says that these flash orders are to blame for increasing volatility, and that if the SEC doesn't act, he will.

"If allowed to continue, these practices will undermine the confidence of ordinary investors and drive them away from our capital markets," Schumer said in a July 24 letter to the SEC.

~~ad_0~~

With all due respect to the senator, political statements like his own often do more to undermine investor confidence than to boost it.

The Dow just had its best July in 20 years, and indexes related to the VIX reflect low volatility, as well. These include the Dow-based VXD index and VXN, which measures volatility in the top 100 Nasdaq stocks.

That doesn't mean that pernicious players aren't out there, ready to unleash volatility with torrents of flash orders and off-the-board trades.

Recent history has conditioned us to be wary of backroom trading strategies where algorithm-driven deluges of shares hit the market. "Quant" (quantitative) hedge funds helped exacerbate the market debacle last year by using automated signal interpretation to shift shares. It turned out that some of the signals — say, rising first-time home purchases — used data that didn't stand up to human scrutiny.

Steve Christ on Flash Orders

Steve Christ, my colleague who has written extensively on the VIX, says the key volatility barometer is down because put (downside option) volume is low.

"If these flash orders were working to the downside, people would be screaming bloody murder," Steve tells me.

Steve and many other seasoned traders liken high-frequency trading to pit trading that proliferated in the 80s, where slight pricing differences were exploited by those physically present and privy to NYSE bid/ask spreads before the broader market found out.

Prevailing logic says everyone should have the same information — or at least be able to find it.

A two-tiered exchange system, then, isn't fair play because whoever has more info can front-run the market.

Yet high-frequency batch traders contend that their supercomputers defragment the market by bringing slight inefficiencies and gaps in data to light, thereby creating liquidity.

And it is true that retail investors make use of high-speed trading technology to boost their own efficiency. All the self-directed accounts or brokerages sending orders every millionth of a second become part of a larger strategy to achieve economies of scale, moving massive amounts of shares quickly. Clearing houses see time as their ultimate advantage, and there are plenty of boring old "buys" and "sells" circulating at the same speeds as new-fangled flash orders.

Like it or not, you live in a world where microseconds matter. Unless you're Superman, there will always be a lag between what you can achieve with your gut instinct and well-placed market bets and the capabilities of firms that spend millions on trading machines.

In short, high-speed trading is here to stay. It's a technological trading advance necessary to keep up with processor power improvements and a growing number of share and ETF offerings, as well as greater numbers of market participants than ever before.

Flash-trading, on the other hand, may be banned if the political echelon really has its torches out. Needless to say, high-frequency trading firms and exchanges that cater to their lucrative business will find other ways to make money in the blink of an eye.

By educating yourself and keeping abreast of all the investment tools at your disposal, you can beat the market bogeyman and minimize volatility in your own portfolio.

Regards,

Sam Hopkins
Sam Hopkins

P.S. Steve Christ's Wealth Advisory is just what it sounds like: not a knee-jerk political response or a psychic's best shot at fortune. . . just top-notch tips and winning investments from one of the best market mavens in the game. His "Lazy Investor's Portfolio," for example, is optimized to keep you in the green and keep volatility out. Even Steve's holdings purchased before last year's downturn are still up into double-digit territory! To learn more about TWA, check it out today.

Buffett's Envy: 50% Annual Returns, Guaranteed