09 July 2010

Computerized Stock Trading Leaves Investors Vulnerable

USA Today

The time it takes to read this sentence is all it takes for nearly 2 million stock trades to flash through the stock market.

Most of those trades aren't coming from trigger-happy day traders and mutual fund managers with billions of dollars at their disposal. It's a flood of machine-gun speed fury coming from an army of computers programmed to obey complicated algorithms that are hyperactively buying and selling.

What does that mean to you, the individual investor? The next time you buy or sell a stock, forget the quaint idea that there is a living, breathing human being on the other side of the transaction. You're trading with a computer.

Not only are the markets completely computerized, more than half of the market's volume is churned by computers programmed to spot certain patterns in trading. These machines see stocks not as securities used by companies to raise money, but rather, symbols, numbers and bits that are traded, swapped and exchanged.

And now, traders say, humans are responding to machines rather than the other way around. Increasingly, too, the machines are reacting to each other, trying to second-guess what their next moves might be on how to take advantage of an edge that might be gone in milliseconds.

"There are no real buyers or sellers," says Joe Saluzzi, trader at Themis Trading. "It's all about the machines."

Never was that as clear as May 6, the day the Dow Jones industrials plunged nearly 1,000 points and then recovered in Wall Street's most volatile half-hour ever. Two months later regulators and stock-exchange officials haven't been able to explain what caused that panic-packed period — except to say that computers likely were to blame.

Given the level of computerization of our lives, from how we play to how we work, it's not surprising technology is how the stock market can handle, process and route the billions of trades that flow through it each day. And computerization is the reason individual investors can buy and sell stocks for less than $10, sometimes even free with some discount brokerages.

But following the May 6 "flash crash," investors are beginning to understand there's a serious and often hidden downside to letting the machines run the markets.

Perhaps most troubling is how computers are giving sophisticated investors with the best digital access to the markets a leg up over regular investors in ways modernization was supposed to do away with. Meanwhile, technological advances are making it nearly impossible for regulators, who play a critical role in maintaining a fair market, to monitor the system that by its very nature has no paper trail and buries transactions in mountains of data.

"It's a war of information," says Gibbons Burke of Morningstar's MarketHistory.com, which compiles statistics of market movements. "Lots of games are being played."

Increased computerization of the stock market is raising troubling problems that have the potential to harm individual investors in the form of:

•Digital "painting the tape." One of the ways traders misled investors in the past was by conducting sham trades with themselves. A trader might enter orders to buy and sell shares of a stock between two entities it controls, giving the false impression there's strong investor interest for the stock at certain prices. This is called painting the tape.

The intent is to fool other investors into thinking this false trading was real, and tempt them into trading based on that information. It's similar to how a crooked eBay seller might improperly use another username to bid on an item, misleading legitimate buyers about the true value of the item.

Painting the tape is illegal. However, modern technology allows traders to essentially perform the same trick in a way that's hard for regulators to detect, says Eric Hunsader, founder of market data feed provider Nanex.

Rapid-fire computer systems allow sophisticated traders, including the giant Wall Street firms, to post bid (buy) and offer (sell) prices they have no intention of actually following through on, he says. For instance, a firm might post a bid for a stock showing they want to buy at a certain price. But by the time investors interested in selling at that price get their order to the market, the false buyer yanks the electronic bid literally faster than a blink of the eye, Hunsader says. This interplay happens in milliseconds, making it difficult to detect.

The computerized trickery is enabled by physics. Since trades move over computer networks at roughly the speed of light, the firms that are physically located nearest the market centers in New York and pay market-access fees get a leg up.

The reason? Each 186 miles a trader is physically located away from the New York trading center, about a millisecond is added to the time to execute a trade, Hunsader says, because that's the speed of light; data can't travel over fiber-optic networks faster than the speed of light.

A millisecond might not sound like much, but it's an eternity for traders who can put up bids or offers for stocks and yank them before other investors located away from New York or with slower connections to the markets can respond. "Trading has gotten to the point where the speed of light is now the major source of latency," Hunsader says.

•Swamping the market with trades. If your e-mail box is filling up with spam, you've already experienced another distortion technology is bringing to the stock markets.

Thanks to low-cost and automated trading, trading firms can swamp markets with a deluge of buy and sell orders in a way that gives them an advantage, Hunsader says.

As other firms must parse through the extraneous trades, slowing them down, the firms behind the pseudo bids and offers can ignore them, saving them milliseconds of analysis time. This gives their computers valuable extra milliseconds to parse true trends in the market and gain an advantage, Hunsader says.

Think of it this way: Imagine that a winning lottery number is e-mailed to two people at the same time, and whoever reads the message first wins the prize. Quickly, one of the people cleverly e-mails millions of spam messages to the other person who also received the e-mail. The spam recipient will need to sort through those e-mails to find the one with the winning lottery number, giving the spam sender time to claim the prize.

The sheer volume of trades is staggering. During the day of the May market meltdown, for instance, more than 19 billion transactions moved, according to regulators. It would take a person more than 100 years to simply count to 1 billion, he says, so anyone who knows some of those trades can be ignored gets a huge advantage.

•Derivatives overwhelming the cash market. Trading firms with the best systems already get a leg up on other investors. But savvy firms can push the market around even more, thanks to other electronic markets that connect with the stock market.

Over on futures exchanges, instead of buying stocks, traders can buy bets on where they think stocks will be in the future. For instance, a trader who thinks the S&P 500 will rise can just buy the so-called e-mini S&P 500 futures contract, rather than buying all 500 stocks in the S&P 500 index.

What makes these contracts so powerful is that they allow traders to make enormous bets with little upfront money: Just $500 in cash can control $50,000 of stock. So a small risk can give traders tremendous sway in the market.

Trading in e-mini contracts has swelled to the point that this speculative market, under the right circumstances, can drive the market for the actual stocks, says Fane Lozman founder of ScanShift.com, a trading firm.

It works like this. Several computer-based trading systems, simultaneously, might load up on large positions betting the S&P 500 will fall. Computers do this by selling e-mini contracts in the futures market at the same time.

But a flood of these robotic sells can have a disastrous effect on stocks on days when the market is already weak. These large e-mini orders will spook the stock market, causing traders and their computers to pull orders to buy the actual stocks on the New York Stock Exchange and Nasdaq. As the market goes lower, selling begets selling. The result is a flash flood of selling and no buying.

"As all these orders from all over the country pile up, no buyer is going to stand in front of that freight train," Lozman says.

Leo Melamed, chairman of CME Group, says market distortions caused by futures are rare and that computer systems offer many more advantages than disadvantages. The explosion of trading makes it easier and cheaper for individual investors to buy and sell stocks.

Technology was supposed to even the field between professional traders and individuals. In reality, though, the rise of the machine on Wall Street shows individual investors are even more outgunned than before due to factors many will never see or perhaps understand, Hunsader says.

But rather than giving up, individual investors need to adjust to a world where computers run stocks, says Larry Harris, professor at the University of Southern California. At the very least, he says, investors should stop using market orders, which is the way most investors buy and sell stocks at the current market price. Instead, he says, investors must use limit orders, which specify a price to buy or sell and can protect them from computers going haywire during high volatility.

It's time now for human investors to adapt to computers, instead of the other way around. Problems do arise from a highly electronic market, but it's here to stay, Harris says.

"The world is a different place because of computers, but there's no hope of returning to manual trading, and you wouldn't want to," he says.

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