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Investors vs. The Machines

Written By Brian Hicks

Posted September 28, 2010

By some estimates, algorithmic trading now makes up 70% of total U.S. stock market volume.

Proponents of algorithmic and high-frequency trading (HFT) say they offer major benefits — improved liquidity, mainly.

They say investors will get better pricing when they buy and sell stocks, due to a smaller “spread” — the difference between a stock’s ask and bid price. A few pennies difference, at best.

This benefit seems miniscule compared to the risk — which we saw firsthand during the “Flash Crash” back in May, as the Dow Industrials dropped 600 points in just a few minutes.

flash crash may 2010


There is little doubt that trading programs gone wild were responsible for the Flash Crash.

Even industry insiders are warning about the dangers of algo and HFT trading. David Weild, former Vice Chairman of the NASDAQ, recently warned of abuse by algo traders.

Here he is, as quoted by The Atlantic:

It is increasingly clear that there are quite a number of high-frequency bandits in the high- frequency-trading community who pump up volume statistics, front-run investor orders, increase transaction costs, and hurt real liquidity.

Clearly, the risk of another Flash Crash isn’t the only thing for investors to worry about.

For example, trading programs increase volatility, sometimes causing wild fluctuations in individual stocks.

algo trading machines

That means trading stops — one of the best ways for investors to protect themselves — are more likely to be triggered needlessly.

Hypothetically, one could make a trading program specifically designed to trigger stops. Muscle a stock in one direction, which will trigger stop orders, and more buying or selling; then take profits as the stock corrects.

The possibilities are endless, and programs are constantly evolving.

There are even rumors of algorithms designed specifically to target their lesser competing algorithms.

And then there’s high-frequency trading, an increasingly large (and dangerous) part of the machine-trading world.

HFT firms “co-locate” their servers next to the exchange’s own, and use this physical proximity to gain a millisecond advantage over everyone else.

They have been accused of front-running other market participants’ orders. In other words, they learn when someone is about to buy or sell a stock, and execute the trade milliseconds before them.

Minimize your risk

Here are a couple ways investors can protect themselves:

1) Buy high-quality stocks for the mid- to long term. Buy and hold isn’t dead; you just have to pick the right stocks.

2) Traders who actively monitor their portfolios may want to avoid using stop orders. This can prevent accidental selling due to an overzealous algorithm.

However, mental stops are still an important way to protect gains and avoid major losses. This technique should only be used by traders who have the discipline (and time) to employ mental stops.

3) Avoid the temptation to day-trade, unless you’re a real pro. This market will pick apart all but the most seasoned traders.

Safe investing,

Adam Sharp
Analyst, Wealth Daily