Posted on 02/17/2015 7:31:08 AM PST by alexmark1917
This is an update to article written a few years ago.
Everybody knows that retail and institutional investors are usually late to a trade. When they decide to buy, the wise guys are distributing or selling their shares to them and locking in their gains. When they sell, the wise guys are accumulating or buying their shares from them, again locking in their gains.
How do the wise guys pull it off? The answer lies in the combination of reflexive human behavior and the use of high frequency, algorithmic (HFA) trading. With the advance of computer trading on a massive scale, large investment banks and hedge funds, which have huge amounts of cash at their command, are able to manipulate the markets almost at will. They use the speed and efficiency of computer-driven trading to move stocks in the direction they want.
They do this by boosting the volume traded in a target company by buying and selling almost the same number of shares at extremely close time intervals. For example, in a buy-then-sell program, they start the trading sequence in a certain stock by buying slightly more shares than they sell at intervals of a few seconds or less. In other words, they are initially net buyers. Note it does not take very much time to establish a huge position in a stock when trades are executed so rapidly. The increase in volume invariably attracts investors, who pile into the same trade thinking there is some positive development at the company. This large influx of net buyers moves the stock higher just like the HFA traders intended. The HFA traders then simply assist the upward momentum they initiated by maintaining their buying and selling at the same level or net neutral while the shares they initially bought increase in value as investors enter the trade at a higher price. At a certain point, the HFA traders are satisfied with their short-term return and become a net seller to late investors, thus locking in their profits and closing out their position. HFA traders can reinforce the head-fake and compound their ultra-short term gain by simultaneously executing the same buy-then-sell routine in the options market. They would simultaneously manipulate call options on the target stock in the same manner, which effectively turbo-charges the deception. The same sequence of profitable trading in the reverse direction can be realized from short-selling.
HFA traders can modulate the size and frequency of their wave trades algorithmically to attract investors and, thereby, maximize their return. The algorithms used by HFA traders are variations of simple software routines. (Input the target company; buy price points and volume; and intervals between purchases. Monitor stock price feedback. As the price moves up, scale back purchases and then start selling at a higher price level to collect a quick profit.) HFA traders have perfected algorithms to make these trades automatically. As a result, they can manipulate the market to their advantage any day of the week. By moving their servers adjacent to the exchanges where they trade (a process called collocation), they reduce the time it takes to execute and confirm each trade. The only difficulty is trying to make their gains not appear so obscene that they attract the wrath of the investors who are their victims.
The analogy would be a wave initiated by fans at a ballgame. A handful of fans start the wave just like the investment bankers do at their trading desks. Once the wave starts, it takes on a life of its own until it peters out. By the time the wave goes one full circle, it takes fewer fans to keep it going. The most energy was spent getting the wave started. After the first full cycle, the initial instigators of the wave can sit down and watch the results. The same is true with HFA traders. They get the trade started with assistance of large-scale, high frequency computer trading and a big slug of capital. Once the wave grows and achieves critical mass, they take their profits off the table. In short, HFA traders ‘head-fake’ their way to massive profits and they can do so anytime they want.
And it gets better. To head-fake other HFA traders, who also trade at warp speed, it isn’t even necessary to put up much capital to accomplish the same result. Manipulative HFA traders simply program their computers to offer to trade a certain stock at certain price, and then they quickly withdraw their bids within a few milliseconds or less before the bids are accepted, thus avoiding an actual costly transaction. When repeated over a short period of time, this causes an upward spike in share volume and price. What appears to be increased buying activity in a certain stock is actually an illusion to sucker other high frequency traders to bid up the share price so that the manipulative HFA instigators can unload the shares and options they already own at a higher price. This is analogous to priming the pump of a stock with short bursts of energy. The technical term for this manipulative HFA trading strategy is called momentum ignition and has been going on for years.
The discussion above describes exactly how HFA traders manipulate the market to ‘earn’ huge profits at will using high-speed computer trading, large sums of money, and reflexive human behavior. It is like the elephant in the room that no one can see, except the HFA traders who are hauling in huge profits. The beauty of the strategy is that HFA traders can head-fake and rip-off a few cents from investors on each trade (which is multiplied by huge volume) and will not be noticed. It is the perfect scam, which insidiously undermines and makes a mockery of our capital markets. And it has been going on for years, enabling the HFA manipulators to haul in boatloads of easy profits 24/7/365.
No wonder HFA computerized trading makes up more than half of the daily volume on our equity exchanges. Traders using HFA computerized trading defend the practice under the pretense that it makes for a more efficient market, but in reality, it simply permits them to steal more efficiently from investors every day of the week. They and they alone are served, while all other investors pay higher prices for the shares they purchase on what is supposed to be a fair and open market. Large investment banks report gains every single trading day, which is statistically impossible unless they are cheating. It is so simple a cave man can do it. Such market manipulation is destroying the underpinning of our capital markets. The outrage about HFA ‘flash’ trading is just the tip of the iceberg. The far more lucrative and insidious form of HFA trading is the wave, which is high-tech pumping and dumping at its finest. If HFA traders can move a company’s shares in any direction they desire, they can move an entire market in any direction they desire. For example, HFA traders can concentrate on a small group of companies within the 30 stocks that comprise the Dow Jones Industrial average to move the average higher. The broader market indices, like the S&P 500 and the NASDAQ, usually move with the Dow and would go higher as well. The implications are enormous for the integrity of our capital markets.
HFA traders at large investment banks and hedge funds have the means, the methods and a strong incentive to exploit investors and have been doing so for years under the radar. In fact, it would be remarkable if they did not do it because the Securities and Exchange Commission has shown no inclination to prosecute such practices, which are clearly fraudulent under the provisions (Rule 10b-5) of the 1934 Securities Exchange Act. Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity, or currency. Clearly, the wave conforms to this definition. With the SEC sitting on its hands, the door is wide open. HFA trading is growing exponentially and exchanges are expanding their facilities to make room for HFA traders’ equipment.
There is much talk about the Plunge Protection Team – PPT. The government does not have to enter the market directly to prop it up. They have surrogates at Wall Street investment banks and hedge funds that act as blowout preventers to forestall or mitigate huge drops in the market. In exchange for keeping the market from crashing through use of high frequency computerized trading, Wall Street firms are permitted to keep their huge profits without suffering any legal reprisals. The SEC simply looks the other way. Government officials benefit when the Wall Street firms kick back a small portion of their obscene profits to fund political campaigns. To make it even more obscene and insulting, regulators purportedly have been studying HFA manipulative trading strategies for years and can’t seem to determine if such activity is deleterious to fair price discovery, which is the cornerstone of our financial marketplace. Even a village idiot, being an apostle of the obvious, knows when something is self-evident. But such powers of observation seem to present an insurmountable challenge to the watch guards and enforcers at the SEC.
The aforementioned plunge protection scheme is not foolproof by any means and could backfire at any time. If some unexpected event or series of events should trigger an avalanche of sell orders, market manipulation to the upside would be overwhelmed and rendered useless, causing HFT traders to automatically close out their open positions and withdraw their bids. Because they control over half of market volume, the paucity of bid orders would leave the market vulnerable to a precipitous fall. The so-called ‘flash’ crash on May 6, 2010 was a preview of what could happen again under such conditions. The result would be severe losses for investors, shaking trust in the markets at its foundation.
Computers and simple software algorithms are replacing and mimicking the old ‘pump and dump’ techniques, which unethical analysts had previously carried out verbally or in writing. In the wake of the dot com bubble, those abuses were exposed for all to see. Now analysts are required to disclose when they have a stake in a company they are touting. One door had closed, but another door opened. High frequency computer traders are faceless and do not have to disclose anything. They can cheat and steal with impunity.
The wise guys always win.
What IS a share of stock in a business ? What is a business ?
We know what a business is, it’s an ongoing commercial enterprise, rings up sales and pays its expenses. What’s it worth ?
You gotta look at its books and understand its operations to know.
A share of stock is part ownership in such a business.
Now think carefully...
How in the world can shares of stock be traded like commodities, like pork bellies or copper or wheat ?
With commodities, the trader has perfect information on the underlying asset - the copper, the wheat, etc.
What are you buying - A BUSHEL OF WHEAT !
Now with shares of stock in publicly-traded companies...
what does the trader know about the real value of the underlying asset - the shares of ownership in the business ?
Does the trader know the real value of the business ?
Hint: he has not got a clue about it.
Why ?
Only the officers of the company can POSSIBLY know what’s really going on in that business.
I would think that mutual funds and pension funds are at a serious disadvantage if they don’t use these techniques. For us little folk, there’s nowhere to turn, with interest rates on savings being so low.
Long-term investors don’t need to worry about this.
When stocks are low, they stay low for a long time, so there’s no need to rush. Throughout most of 2009 and 2010, you could buy top companies at 8-10 times trailing earnings. Did institutional investors rush into scoop up these fantastic bargains? No.
Not unlike the way cops turn a blind eye to some petty criminal activities in exchange for the occasional information they may want from these sources. A convenient arrangement for both parties as it were.
Interesting behind-the-scenes article. Thanks for posting.
The trader may not care about the real valuation of the business. They are traders after all, and not long term holders of the stock.
But it is possible to calculate the valuation of a business for purposes of establishing a company's intrinsic value as an investment. In fact, there is no shortage of investment services or industry analysts who do this type of thing. Their assessments are readily available. Unfortunately, they don't universally agree on those valuations because of the underlying assumptions to the valuation models that are usually based on a discounted cash flow analysis. In the final analysis its all about a company's ability to generate future earnings and there is also no shortage of such historical information or projections.
From a mathematical perspective it is possible to determine what a company is worth (i.e., its intrinsic value). But lots of things, including the quality of company management, go into assessing a company's future ability to grow its earnings and/or pay a reliable stream of dividends.
Its a fascinating area to study.
Do you see the difference ?
A bushel of wheat - versus a fascinating complex study of business valuation.
Mind you by trader, I mean anyone who buys and sells stock, including joe and joanna six pack.
what does the trader know about the real value of the underlying asset - the shares of ownership in the business ?
Does the trader know the real value of the business ?
Close, they only know when quarterly reports are issued, all others are pure speculation,rigging the game.
The speed of light is now making financial centers like Noo Yawk important again. Getting closer to the broker server gives you a speed advantage.
Do you know why joe and joanna six pack should be investing mostly in bonds instead of stocks ?
Do you know why joe and joanna six pack should be investing mostly in bonds instead of stocks ?
Do you know why joe and joanna six pack should be investing mostly in bonds instead of stocks ?
Do you know why joe and joanna six pack should be investing mostly in bonds instead of stocks ?
No. Bonds are a bubble that will eventually implode, but no one knows when.
Pension and mutual funds don’t “trade” stocks, they invest in them. HFT algorithms create “noise” in the trend pattern for stock prices. Long term investors don’t care about the noise, because they invest based on long term trends which aren’t impacted at all by the noise.
In fact, the best long term investors almost never sell anything, they simply rebalance their portfolios by using their dividends to purchase more securities in the underperforming sectors of their portfolio, knowing that sectors are cyclical and the underperformance won’t last forever. Once they have accumulated enough dividend paying stocks, they live off the dividends and eventually off tax free bonds purchased with dividends.
Small investors who think and invest like pension funds can easily become independently wealthy by investing 10 to 20% of their income, depending on their annual salary. Social Security could have made every virtually every retiree in the United States a millionaire if the payroll taxes were responsibly invested, and the US economy would be growing at 4 to 6% per year with the added investment momentum.
Warren Buffet’s main focus is on buying stocks well below their intrinsic value, or in some cases at their fair value. A conerstone of his investing is establishing the intrinsic value of any company he is considering investing in.
But what does Buffet know? He’s only one of the most successful investors in history. BTW, he is a disciple of Benjamin Graham who did pioneering work in this field. You may want to re-think the bushel of wheat thing. Stocks are not commodities.
Exactly right. Bonds are one of the riskiest investments out there today. When rates eventually rise, and they will, bond prices will go the other way — big tme. That’s the way bonds work. The longer the term of the bond you’re holding, the worse the price decrease will be.
Joe six pack does not have Buffet’s knowledge or information.
Joe is wise to invest in small business that he controls directly through himself and partners. He’ll have full access to books and records, the sales pipeline, costs, etc.
In the event of bankruptcy, bondholders get paid before stockholders. Bonds have a principal amount which is their underlying value net of interest. But Joe investing in bonds is neither here nor there, because it’s just not done. Joe is told to invest in publicly traded equities, and even more he is told to invest in retail funds. Joe is not allowed to invest in opportunities for “accredited investors”. So Joe turns his capital over to the elites and they manage it for him, and they mostly get paid by Joe for managing his capital whether Joe has a gain or a loss in their funds. To the elites, the key is controlling how capital is allocated: which business gets the investment. Joe does not make that decision with his capital, the elites do. Joe thus does not determine ANY corporate policy as well; the elites determine corporate policy.
Trading markets of stocks, bonds, commodities - all of those markets - Joe six pack has very poor information about and he is on the outside looking in.
From time to time, markets go into bear mode and fall precipitously, and Joe’s holdings get hammered. But he does not have to recognize the loss if he does not sell. So Joe is fine with a Buffet-style long-term investing. Unless the big crash happens when Joe is old and wants to start living off his investments. Then Joe is in a world of hurt.
Alternatively, Joe and his partners can determine corporate policy in businesses that they directly own and control, they can know exactly what is going on inside their businesses (and properties of various kinds), and they are not affected by “market value” of their investments because their investments are not traded on a public exchange.
Joe and his partners do need to have the brains and ambition to run their own businesses however, and collect their own rents and loan payments, etc. They also are well served to be diversified, of course, and can certainly invest in public markets opportunistically, where the risk is low and their information is good, and these investments are only a small part of their portfolio.
If Joe is running a successful business (a good way to build real wealth) then he probably does not spend the time and energy it takes to be an informed or opportunistic investor. Growing a business enterprise is a very time consuming thing so naturally he does not have Buffet’s degree of knowledge or information. But, that shouldn’t prevent him from finding successful companies that have remarkable track records of earnings and dividend payouts. Just scan the list of Dividend Aristocrats for plenty of potential candidates.
The point is, the average person doesn’t put much effort into selecting investments. They spend a lot more time evaluating autos or refrigerators. For those folks, investing in the S&P 500 is probably the most suitable investment for them. It is a well know fact that most fund managers cannot beat this index for any length of time. And the ETF fees are extremely low so you don’t have to waste money on high fees.
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