TRADERS RULE

What do the wild, short term swings in the Dow and other indices mean? How much of the activity causing swings is induced by short term, high frequency trading (HFT)? Is this healthy?

Viewing the wild swings from the vantage point of history suggests that short term “ups & downs” provide little, if any, insight into the medium or long term direction of the market, except in unusual circumstances. The fact that the Dow may fall 200+ points on Monday and recover 200+ points on Tuesday makes the market look irrational particularly when there has been no game changing event reported. Reports of negative news of one industry or company are micro-economic events, and logically should not influence markets in a manner that might be expected when there is a macro-economic event.

If this observation is realistic, then it might be postulated that short term, high frequency traders, judging time in terms of minutes or hours rather than months or years cause this market volatility. It seems obvious that the typical, individual investor buying or selling 100 to 1,000 or more shares of X stock would not move a market one way or another Moreover; the typical individual investor would not sell out a position on the belief that their stock would decline by $0.25 per share tomorrow. Instead, they would hold on to the stock if they continued to believe in the future of the company.

There has not yet been any definitive study indicating whether or not HFT is good or bad for the market. There is some evidence that 50% of all trades are HFT transactions. Some have argues that the market liquidity available because of trading activity is good for the typical investor both in terms of keeping transaction costs down and limiting volatility. But, there is no definitive study supporting these conclusions. Logic persuades that if 50% of the shares traded are the result of HFT activity, which, in turn is predicated on a short term view, the short term trading causes volatility. Moreover, the short term trader is more of a gambler than a typical investor. From the standpoint of the individual investor, with their investments in IRA’s, stocks and/or mutual funds, day to day volatility is unsettling and confusing.

Much of the confusion is caused by the “talking heads” at CNBC when they talk about what “investors” like and don’t like. But, are they talking about the typical individual investor? That is very doubtful since the orientation of their commentary and the commentary of their guests seems mostly framed in the short term unless they are reporting on people like Warren Buffet. Their commentary seems focused on the traders and institutions rather than individuals. While it is probably good theater for the viewer, it is doubtful that individual investors learn much that will guide a buy-sell decision now or tomorrow.

Another deviation from the sphere of typical investors is the frequent reference, by the “talking heads” to XYZ making a BET on a certain outcome. The word “bet” very frequently crops up in broadcast and print financial news. It should be obvious that short term traders, trading thousands of shares at a time, in mille-seconds, are “betting” that a stock will rise or fall in value in the very short term (minutes rather than days or months). It has been said (but not proven) that the holding time of securities bought by high frequency traders is less than 10 minutes. If they bet right they win. The typical, prudent investor does research before purchasing a security. It is doubtful that the HFT trader does any material research into the companies they trade and are in every sense gambling on an uncertain outcome that is algorithm based.

What is interesting is the fact that there are both Federal and State anti-gambling laws and 19 states disallow social gambling. The legislative purpose of these laws seem to be to protect the citizens against shady people running card and dice games for their profit or to eliminate the corruption of “fixing” in sports betting. Much has been written about prohibiting on-line, internet betting despite the practical impossibility of effectively stopping it. But, if risking money on an uncertain outcome is gambling, then Wall Street provides the largest casino in the world, although one in which there are numerous rules to protect the investor against misrepresentation and fraud.

HFT is not a strategy available to the typical investor and benefits one specific group rather than all participants. Is it otherwise bad? Probably not unless it is clearly demonstrated that HFT induces a higher degree of volatility into the market than would otherwise exists. But, this research has not been undertaken. One fact, however, jumps out. HFT activity does not appear to add anything to the GNP of the U S. To the extent that lawmakers might come to the conclusion that HFT is a form of gambling they might wish to consider a transaction tax of $0.25 per share or $10 per transaction, whichever is less, on all securities purchased and held for less than 48 hours.

One thing is sure – the stock market does not provide a level playing field.

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