by David Dreman
Further illuminating the problem, in an interview with Bloomberg News, Gary Wedbush, executive vice president of Wedbush Securities, whose company is one of the biggest execution and clearing firms catering to HFT, said, “Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.” Wedbush added, “We’re seeing a tremendous amount of high-frequency trading. Their business is a trading business, and volatility creates far more opportunities.” Putting a fine point on the matter, he further stated, “You can look at a VIX chart [the most widely used volatility measure] and that’s almost perfectly correlated to high-frequency trading volumes [italics mine].”10 What Wedbush is saying in non-Street parlance is in effect that high-frequency trading is a primary cause of the panic because it was the prime reason for the enormously increased volatility of stock and index futures prices. Remember in the flash crash stocks fell as much as 60 percent or more because of similar volatility in minutes.
The skyrocketing volatility, while highly profitable to HFT traders, terrified almost all institutional and individual investors because of the rapidity of the moves both up and down. Such volatility in a very short time period was almost unheard of. This is a proven way to create market panic.
Along with many others, I find it difficult to say the HFT group are legitimate market makers; to many, including myself, they can be far more accurately thought of as major destroyers of wealth.
Some traders believe that the market volatility during this period was due to market manipulation. A number of knowledgeable traders interviewed on CNBC strongly agreed. Jon Najarian said that everything that happened since August 3 deserves to be the subject of this debate. He particularly cites the 33 percent increase in the capacity to report trades in the Consolidated Quote System to 1 million quotes per second on July 5, 2011. “In a turbulent market,” he continued “[investors] can’t even see what’s going on.” Other traders agree. Tim Seymour says, “It reeks of manipulation.” Trader Joe Terranova said any way you add it up, it equals trouble. “Because of machines, things are happening much more quickly and much more deeply.” Jon Najarian added, “We need the SEC and the CFTC to step in and say ‘no more.’”11
Some high-frequency tactics have in fact attracted the attention of regulators. They are probing into whether laser-like orders placed in large batches and withdrawn in milliseconds have distorted security prices, particularly if they were placed almost at the same time by a dozen or more firms using similar algorithms to trigger them. If the market is moving down sharply and a tidal wave of potential sell orders suddenly appears to be coming in, the natural tendency is to get outta Dodge fast.
The SEC in these weeks subpoenaed a number of HFT firms’ records to analyze their role in major swings, including the flash crash, as well as to probe into other activities not related to it. SEC chairman Mary Schapiro said in a speech earlier in the year, “We need to assess the entire regulatory structure surrounding high frequency trading firms and their algorithms.”12 An issue she highlighted was whether these algorithms work properly in stressed markets. According to CFTC commissioner Scott O’Malia, three other such crashes that have occurred since the May 2010 flash crash have also been related to algorithmic trading.13 The Justice Department and SEC are now investigating whether HFT practices may be manipulative.14
Actions on HFT spread to Europe months ago. Similar reactions in these markets resulted in Europe’s top securities regulator, The European Securities and Markets Authority (ESMA), outlining a series of tough new rules to clamp down on HFT. The rules will be fast-tracked to passage by including them with two existing pieces of security legislation, and should be adapted in 2011. The rules are being introduced after NYSE Euronext suffered three trading halts due to excess volatility in six trading days earlier this year while alternative platform CHI-X suffered three stoppages in May and June. Andrew Haldane, executive director for Financial Stability at the Bank of England, said in early July that the rapid growth of high frequency trading caused price “abnormalities” and was raising contagion concerns.15 More new evidence questioning high frequency practices seems to come in almost daily.
What seems clear to me, if anything can be clear in the murky HFT environment, is that high-frequency trading may be used for many dozens of trading strategies. But in my opinion from what we’ve seen, in these two recent periods of market crisis, one strategy stands out. The HFT traders use their enormous speed, measured in thousands of a second, to accentuate market moves up or down. If markets are down a few hundred points, as in the flash crash, and selling begins to pick up, HFT firms short S&P futures or other stock vehicles heavily. All of this is computer driven because of the enormous speed required. HFT firms can also be very active on openings and closings, when the market is down or up fairly sharply, accentuating the moves in either direction significantly.
It would seem the algorithms of most HFT firms are programmed similarly for this type of scenario, so if one flash trader begins to short the computerized algorithms of many others, HFT firms fire off short sell orders almost instantaneously. We have already seen how this tactic worked in the flash crash to drop the Dow 600 points in eight to ten minutes and can lead to widespread contagion in the marketplace. The panic moves through the S&P stock futures pits into the stock market itself and results in the selling of individual stocks. As we saw in the flash crash, the carnage was very heavy, with many stocks dropping as much as 40 to 60 percent.
We also know that the HFT firms fire off enormous numbers of bids or offers for futures and stocks in milliseconds and cancel them a few milliseconds later. Some of the reasons given seem valid, such as trying to uncover a buyer’s position. But this is very different from placing enormous orders that they don’t intend to follow through on. The latter practice in a sharply falling market is dubious at best. One reason in a panicky market might be to drive prices even lower. If a flotilla of HFT firms are attempting to drive prices down and a large tidal wave of flash sell orders show up on the screen, canceled in milliseconds, other investors can easily be fooled into thinking that heavy potential waves of selling will hit the floor in seconds, resulting in investors and traders selling immediately to escape the deluge.
The same strategy may apply in a market which is rising substantially, only in this case the tactics would be used to keep the market rising, and if possible on an accelerated basis. HFT firms thus win on both the upside and the downside. All they require is enormous volatility in either case, which from the evidence available they help to create. The net result is that volatility is far higher than it should be and all too many people abandon markets because of their casino-like behavior.
Markets thrive on low volatility and a stable environment in which to make investment decisions. Flash traders thrive on instability and rapidly rising or falling markets. The very instability they require to make major profits is what drives tens of thousands of investors out of the marketplace as we have seen. It is interesting to know how attuned flash traders are to the art of creating panic by aiming to increase the market’s volatility. Their profits in the August 2011 crash were huge while most investors, including most professionals, lost money. For HFT firms to make instant profits by these activities is certainly against the best interest of the overwhelming majority of market participants.
The HFT firms’ actions are not unlike the allegoric snowball that rolls down the mountain gathering mass and creating an avalanche. Remember we’ve heard a number of times from HFT participants that the more volatility, the better. HFT firms like it because it does create great volatility and what they don’t say—major panic.
We don’t know yet whether there has been manipulation by some of the major HFT firms. But if my portrayal is correct, this is not only a challenge for the SEC, it is a serious challenge for investment professionals and individual investors, in their efforts to keep markets sound. This band of traders who hav
en’t the least interest in owning stocks or indexes themselves or participating in markets for more than a few milliseconds are a real danger to markets as we know them. Though destroying our markets, which high-volatility trading does, is certainly not intentional. The last thing the HFT firms want to do is kill the goose that lays their golden eggs. But it would seem that in their rush for profits that’s exactly what their actions threaten to do.
How can we stop this major threat to markets? It won’t be easy. As we saw, we faced a similar situation during the 1987 crash because of the interaction of index arbitrage and portfolio insurance. However, in 1987, the explosion was accidental, while here it seems to be intentional. HFT seems to be a far more effective weapon to keep volatility high over prolonged periods of time, if not dealt with quickly.
One solution might be to raise the margin requirements up to 25 or even 50 percent for these firms on the stock futures they trade. Another would be to place limits on the size of positions they can buy or sell very quickly in S&P 500 and other futures, which do disrupt markets. A third is the SEC’s proposal in late September to set tighter limits on circuit breakers, reducing them down to 7 percent from 10 percent, and using the much broader S&P 500 instead of the Dow Jones Industrial Average.16 A fourth is to increase the transaction costs per share slightly on trades. Since most HFT firms trade for profits of only a fraction of a penny a share, marginally higher transaction costs will sharply reduce their trading. I’m sure sophisticated thinkers on the matter can come up with many more. Hopefully soon, because our markets do seem to be seriously threatened.
A Fast Track to Disaster?
The SEC’s and CFTC’s mission is to protect the public, not a group of brilliant computer jocks in T-shirts and jeans whose sole reason for being is to rip off investors by getting an edge on their trading. If the traders provided a consistent legitimate service and did not increase the danger to the average investor or mutual fund, it would be hard to find fault with their activities. But from what we’ve seen from our brief overview of the flash crash and the far more devastating drop in late July and through September 2011, this does not seem to be the case. The SEC itself noted that in the flash crash, volatility increased as the stock market crumbled. Moreover, practices such as bid stuffing, where an HFT trader can fire and cancel thousands of shares a second, and other schemes we have viewed, are potentially very dangerous.
These strategies have been put together by some of the smartest people in the investment business after investing tens of millions of dollars in the high-speed systems and the professionals necessary to make them work. It doesn’t quite seem that they are doing it for charity. Knowing what we know, we see that flash trading may be a danger to both the public and our major financial institutions. Although this writer and many others believe there is widespread manipulation caused by HFT, the SEC is still investigating the charge. Many of us are curious why HFT trading firms seem to be the only ones making large profits through these debacles. The end result is that the damage to investor savings and to their confidence in our markets has been enormous. There are certainly serious questions to ask about its many moving parts that require thorough analysis. The prudent move to protect the large majority of investors would be to severely restrict HFT operations until these questions can be answered.
What Should You Do?
If I am right, there are a number of ways you can get hurt by high-frequency trading. The worst, of course, is if HFT causes a serious crash. But this is not a reason you should get out of the market. First, the regulators are moving slowly in the direction of taking action on this issue. A worst case is that they wait too long and the wheels come off the market. In this case, if the facts are widely known, I’d expect the market to come back fairly quickly in a manner similar to the recovery rally after the 1987 crash.
However, there is something you can do to avoid being bloodied in the interim. High-frequency traders can profit big-time from a panicky market that they’ve created, though most traders would swear on their mothers’ lives that it isn’t true. To avoid this, do not put in stop-loss or sell-at-the-market orders. Instead, always put in limit orders, which limit the price at which a broker can sell. If you do this, your stock, derivative, or futures contracts cannot be sold off many points down in a crash. Don’t use stop-loss orders until the problem is cleared up, or you could lose big. Stop-loss orders worked in the past, but, given HFT, they could be as bad in these times as Russian roulette.
Volatility Twisters
High-frequency trading, which instigates enormous volatility, is but one threat in the, at times, alien world we are in now. The possibility of greater volatility, aside from that generated by these crashes, is another. Volatility was at more than three-year lows in June but can change on a dime and can continue to fluctuate violently with any sharp move in prices or serious financial or economic events. In the fall of 2008, fear shot up like the flames of a roaring forest fire. Some investors tried to protect their blue-chip stocks by buying puts, which gave them the right to sell a stock at its then-current, highly depressed price if the market went lower. The cost to do so can be exorbitantly large with ultrahigh volatility, premiums sometimes rise to 20 to 25 percent of the entire principal for 90 to 100 days. For a year, if the put premiums remained relatively unchanged, the cost increased to 80 to 85 percent annually. For some of the smaller names, option prices rose as high as 130 percent annualized.
In effect, the insurance provided by buying a put would have almost wiped out any blue-chip portfolio in little more than a year. Insurance rates through buying puts, as a matter of comparison, were far higher than those Lloyd’s of London sold on merchant ships and their cargoes coming back from the New World and the Far East in the eighteenth and early nineteenth centuries.
What I hope this example shows you is that in periods of crisis, using options clearly does not work. The person taking the other side of the trade is usually an experienced trader who has almost fully protected himself from the risk you are trying to shed and is probably charging you a pretty healthy premium above the going rate for the risk, because there are so few traders who even want to do the transaction.
There are other alternatives, such as shorting against the box, that are less costly, if you’re bound on this course, but again the problem when we sell in a panic is that we are normally near the bottom. Even if you protect your downside, shorting against the box leaves you with no stock position if the market rallies. If, for example, I had forgotten my contrarian training and panicked in March 2009, when stocks were approaching their lows, this tactic would have resulted in my totally missing the market upside of over 100 percent for the S&P 500 to June 2011. The trouble is that this happens all the time.
About a decade ago, the head of customer service at our firm grew nervous about the market and took all of his funds out of stocks because he thought the market would go down another 5 percent. I advised him not to do it because market timing rarely worked. He followed his inclination and proved wrong. Before he bought back into the market, stocks had advanced another 10 percent. Fortunately, our firm does not market-time, nor do we do so for our clients.
Volatility, unfortunately, is something we just have to live through. Yes, every eight or ten decades or so, we’ll be wrong to do this, but we or our families will have far larger portfolios in the end if we stay the course. Recall also that contrarian portfolios, on average, outperform the market on the downside.
Protective Actions
PROTECTIVE ACTION 1: PUTS AND CALLS
Should you buy puts and calls to protect your portfolio? We’ve just said that puts are not a good investment in a panic. Put and call options can protect the investor in a volatile market. An investor can stay out of the market and buy a call option if he thinks prices will rise. If he buys it at today’s market price, he will pay a hefty premium and be able to call the stock at that price. Similarly, in a more normal market, if he thinks the market is going down, he could
sell a put and for the premium be able to sell at the market price or close to it for a period of time; the longer the period, the higher the premium.
This may sound simple, but in a volatile market it is a devilishly tricky game. First, premium prices are high, and the greater the market volatility, the higher they become. In December 2008 and January and February 2009, premium prices rose as high as 20 percent, as noted, for some stocks on a quarterly basis and much higher annually. This means that if you buy a call option that gives you the right to buy a stock, you could pay a good part of the principal to hold it for, say, nine months. If it goes up 50 percent, you still might come out only breaking even. Great idea, but the cost is often much too high.
There is also a series of options issued on each stock that makes this exercise far more difficult to calculate. And then there are the sharks. The options traders want to get as much of an edge on you as they can. Hey, that’s the game. What this translates into is that you pay the normal premium (calculated by the Black-Scholes model)*72 and something more, possibly a significant amount if the stock is illiquid, to the seller.
The bottom line here is not to buy puts or calls unless you are highly experienced with them. Even then, the odds are against most people. On the other side, never, never sell these options unless you are very well trained in all the risks they entail.
What about the VIX that we just discussed in some detail; does it help investors to protect themselves in markets such as these? When volatility moves up sharply, buyers of VIX products will make money, and when volatility moves down sharply, they will lose money. This is one of the ultimate new market casino games. The VIX is a statistic that the CBOE calculates and disseminates using real-time S&P 500 Index option bid/ask quotes. Though widely disseminated, this statistic is not available for purchase.