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Thoughts on High-Frequency Trading, Investor Psychology, and Market Volatility

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Investor psychology plays in favor of high-frequency traders; their primary goal is to have extreme volatility, heavy volume so their black boxes can jump ahead of everyone else's.

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As we continue to be whipsawed back and forth by tremendous volatility and emotion, I wanted to further address the topic of high-frequency trading coupled with investor psychology.

Lately my tirades about front-running, high-frequency traders (HFT) are getting some serious company from serious people in multiple interviews – now we wait for the SEC and perhaps our old friend, Barney Frank to wake up... Just yesterday, I saw an interview with two money managers who have been in the investment business for decades, who employ far different styles when it comes to managing their assets, but who agree almost completely that high-frequency trading is basically legalized stealing and can't believe the SEC (& NYSE) continue to allow and almost encourage the activity. (They were: Marvin Schwartz, MD & Sr. PM at Neuberger Berman – and Leon Cooperman, Chairman of the enormous hedge fund firm, Omega Advisors.)

I've done a lot of thinking on this topic of late as I've watched the flickering ticks go by in multiple-percentage, daily swings (is this the "new normal?") and it's almost as though you can watch the machines at work. The best analogy I can think of to illustrate my point is a snow-making machine at a ski resort – you can easily see it when it's turned on or turned off.

Throughout the day yesterday we had an initial blast lower which ran completely out of control in early trading (HFT "making snow") – then the machines were seemingly throttled back, volume dropped, we caught a little bit of a bid, but most importantly it simply felt like a lazy summer day. Until… around 2:30 - 3:00 p.m., they started making snow again. Almost magically the volume spiked, the emotions dropped, and the market fell 100+ points in just a few minutes as the TV bleated its negative message. Then, as if they wanted to escape political blame and finger-pointing, about 10 minutes before trading came to a halt for the day, the snow machine was once again turned off and the Dow gained back almost 100 points, lickety-split.

What does this all mean and how can it change? Schwartz & Cooperman both reminded me of a point I've outlined several times – the elimination of the uptick rule in 2007 is what basically allowed HFT to flourish. I've discussed in painful detail previously what HFT is and basically how it works, but the "uptick rule" is even simpler: Prior to 2007, if you wanted to sell a stock that you didn't own (sell short), you had to sell into an uptick in the price. (i.e. If the last trade was $50 for the stock you want to short, you have to sell your shares at $50.01 or higher). And it used to be a 16th or 6 ¼ cents, before decimalization, but don't get me started on that change. Now you can merely pile in with all the other "long" owners as the shares drop in value. Remember, HFT works on speed – and emotion; slowing the flow and having to "work" an order almost completely removes the machine's advantage, and at the very least, would minimize the volume spikes.

Our old friends in Europe attempted to implement their own, clumsy, volatility solution Tuesday by proposing a "transaction tax." The thought would be that every single trade would have a small tax attached, which would serve to deter the high volume of trades necessary to scalp a profit in the HFT model. This seems odd to me, because although it does fit into the general, liberal European politician's mind of revenue generation via taxation for redistribution, it seems to also be an odd admission that people will alter their behavior to avoid paying taxes. (Haven't we been hearing just the opposite in our political discourse lately?) Hmm...

(See also: European Transaction Tax Would Create More Problems Than It Solves)

The argument has also been made that the markets "need" the liquidity provided by the HFT crowd. Several of the studies I've read seem to indicate just the opposite. One report in particular concluded that once things broke on high volume, the HFT machines would jump in and accelerate the volatility (make snow), and then when it was really needed to change direction or other orders showed up, they would simply walk away. (Snow machine, off.)

My fear is that the transaction tax probably will curb HFT as intended, but it also may curb the "good" liquidity from the rest of the market participants as well by penalizing everyone and not simply the bad actors it hopes to marginalize. Not a real confidence builder, for sure.

Many of the market reports yesterday spoke of "a buyer's strike" – meaning, there was just a lack of demand on that side of the trade, and people chose to sit and watch. Guess what that environment doesn't provide very often? Correct! Upticks! Possibly more evidence that simply reinstating the uptick rule would be a free and easy way to negate the incredible volatility at the worst possible moments of trading.

The other unnecessary restriction that our friends in the EU came up with this week was the banning of the short-selling of financial stocks because of the outlandish rumor-mongering going on. Again, the little Dutch boy has his finger in the dyke, but that isn't a longer-term solution. Short selling by thoughtful people isn't bad – it does add liquidity (you may have heard the term "face-ripper" lately when it comes to upside volatility) and most short-sellers do more homework for their unpopular stances than long holders do because of the inherent upside bias of the markets over the longer term.
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No positions in stocks mentioned.
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