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How Algorithms Affect the Market

Written by Briton Ryle
Posted December 4, 2017 at 7:17PM

So, this past Friday, at approximately 11:05 a.m. ET, ABC News reported that Trump's former advisor Mike Flynn had agreed to testify that the president ordered him to contact Russia about how to end-run new sanctions coming from Congress. The Dow Industrials was trading up about 40 points at 24,310 when the news broke. 

Twenty-five minutes later, the Dow had peeled of nearly 400 points down to 23,927. 

It's pretty easy to imagine why stocks would tank on this news. The question of whether Trump was trying to gain favor with a country that does not have American interests at heart aside, Flynn's testimony would mean that Trump lied to investigators and probably would open the door to calls for his impeachment. It also might have weakened the Senate's resolve to pass the tax reform bill. 

Of course, we now know that ABC's report was wrong. Yes, Flynn had agreed to cooperate with the investigation. But there was no specific agreement to testify against the president. This was, for lack of a better term, fake news. The reporter has since been punished for misreporting the story (four weeks of unpaid suspension), but the damage was done. 

A lot of traders were long when that story broke. I was one of them. I had a handful of Bank of America calls that were up around 20% on the day. Within minutes I was taking a loss, because you don't want to try to hold a long position into a freefall. 

The speed of that decline is a pretty good example of how the stock market operates these days. Computer-based trading systems can turn on a dime and run stocks down a few hundred points before you (or I) can get the "sell to close" button up on your monitor.

The Algo "Problem"

We hear all the time how computer-based stock trading systems are manipulating the stock market, making it impossible for individual investors like you and me to ever get an edge. Conventional wisdom says that these trading algorithms — or "algos," as they are commonly known — are the root of all evil for the stock market...

  • The computers "know" what you are buying and selling and they work against you, taking your money and putting it in their pocket.
  • The machines have driven the stock market to insane bubble levels, and a crash is inevitable.
  • Algos all work together to manipulate certain stocks higher and others lower, creating huge profits for themselves.
  • Algos make the stock market unfair for individual investors and should be outlawed.

There are a couple things I love saying to my kids. There's "Well, what'd you do that for?" when they tell me they stubbed their toe. The always-popular "I don't know, can you?" when they begin a request with "Can I...?" instead of "May I...?" And finally there's the ultimate classic Dad response: "Life's not fair." 

Look, I hate losing money as much as anyone. But you know what? The stock market isn't fair. And it isn't supposed to be fair.

Well, let me qualify that for a second. Yes, everybody should have access to the same stocks and the same pricing. And really we do. If you wanna buy Apple at $171.38, you probably will be able to, and you might be buying your 100 shares right alongside a hedge fund's 100,000-share order.  

But when it comes to access to information and the decision-making process, the stock market will never be fair. In fact, the term "fair" doesn't even apply. It's all about having an edge.

The First High-Frequency Trader

After he returned to power in March of 1815, Napoleon Bonaparte was declared an outlaw by the Congress of Vienna. Faced with an imminent invasion by an allied force (England, Russia, Austria, and Prussia), Napoleon opted for a preemptive strike of his own. 

On June 16, 1815, Napoleon defeated the Prussian army at the Battle of Ligny. When he learned of the defeat, the Duke of Wellington decided to retreat with his English army, as he expected that Prussia was routed. Wellington retreated to Waterloo when he finally learned that Prussia was not routed. They had retreated and could still support the English army. 

Still, victory for the Allied armies was not assured. Wellington later said the battle was "the nearest-run thing you ever saw in your life..."

While the smoke was still clearing, a carrier pigeon was let loose to bring the news of the English victory to Nathan Rothschild, who made a killing buying up English government bonds. 

Yeah, Wellington never actually said the battle was "the nearest-run thing you ever saw in your life." And while the Rothschilds did use carrier pigeons to ferry news as fast as possible, there's no evidence this happened after Waterloo... 

But the point is traders have always gone to great lengths to get an edge. And they always will. 

Hedge funds hire doctors to evaluate new drugs from biotechs. They don't blink an eye at paying $20K for a research report. They might even buy enough stock to get themselves a seat on a company's board.

Any of us are free to do the same thing to put the odds in our favor. But the simple fact is, you don't have to go to such extreme measures to get an edge in the stock market. 

Twenty years ago, I was just starting out in this business. I could see the massive profit potential, but I was a trading novice. I'd win one trade and lose the next, basically spinning my wheels. That's when I decided to make a bold move and give myself an edge that would last a lifetime.

Tomorrow, in a special presentation, I'll tell you about my pilgrimage to a trading Mecca and what I learned.

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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