Over the weekend, I was putting together some resources to explain to my FTM and Market Timer members how individual stocks are manipulated by large players like hedge funds and HFT/algo shops.
I had no idea that Michael Lewis had a new book out about the topic titled Flash Boys and that he was featured on 60 Minutes Sunday night. His investigative work inspires me to go further in helping investors and traders understand the brave new battlefield we play on.
The markets ARE rigged and I am going to attempt to prove it to you. Then I’ll offer a set of solutions for investors.
I have deep, first-hand experience with the battle. In 2000, when I was an FX market maker and spot/futures arbitrageur, I noticed an odd type of price behavior in the currency futures. There was an immediate and consistent buy or sell response to certain price movement that could only be explained by an automatic execution program.
For example, if I hit a bid or took an offer, there was suddenly a 100 lot offered or bid there. Back then, you could always see who the clearing member was for any given counterparty you just traded with. Based on my knowledge of that firm and its customers, I figured out that I was trading with an automated model from futures legend Monroe Trout.
Suddenly, in the futures markets in 2001, the technology arms race was on and firms were scrambling to write code and “co-locate” their servers next to exchange hardware to reduce “latency” and run their algorithms with the fastest execution results.
By 2007, I saw the writing on the wall and left that FX desk before computers took over all of arbitrage (which they did). And as I entered the world of equities full time, I saw the “rise of the machines” in full force. But I never saw the trend as a bad thing.
In fact, the day after the May 6, 2010 “flash crash,” I appeared on British television with Richard Quest to explain to Europeans why the US markets weren’t broken. Yes, there was damage done that day to small investors and confidence in the system. And, yes, we needed controls to slow down the machines and prevent another waterfall cascade.
But I also stressed that the technology genie was already out of the bottle and we wouldn’t want to put him back because HFT/algo trading enhanced market liquidity for all players, big and small. The Flash Crash was our growing pains moment in high-speed market technology.
And despite the “games machines play” (I have a descriptive list of over 20 algo programs that exploit investors and traders with price behavior manipulation), often the machines will “eat each other” and thereby keep the monsters in check. You don’t often hear about the HFT/algo shops that lose and go under.
Speaking of the games machines play, in case you don’t know what I mean, here’s a quick list of strategies and tactics algos can be programmed to execute with hundreds of different parameters:
- generate buying/selling activity in individual stocks to create illusions and gain better price advantage for the opposite effect (selling to buy, buying to sell)
- exploit traditional technical analysis with detailed programs that force breakouts and pattern confirmations only to attract money and interest and then reverse the action to create failure
- run stops in various time frames like nobody’s business
In short, hedge funds and HFT/algo shops can bank coin on choppy markets like a casino collecting the vig all day long.
But the only thing new about all these games to exploit investors and traders is the bits and bytes. In the 1930’s a market legend named Richard Wyckoff wrote a manifesto that gained him a cult following on Wall Street.
His 1931 book, The Richard D. Wyckoff Method of Trading and Investing in Stocks: A Course of Instruction in Stock Market Science and Technique, is must reading for understanding how larger players must manipulate stocks to get in and out.
Since then, the markets have become vastly more sophisticated and liquid with various levels of players between us (the little guy trying to secure retirement) and them (the institutions running billions).
But the one thing that hasn’t changed is human behavior. Greed and fear still rule. And the former drives the pros to exploit the latter (and our natural greed) by any means necessary. And I’m not talking about the cheaters like Raj Rajaratnam, Stevie Cohen, and a thousand other thieves who will never be caught.
I’m talking about the capital groups, characters, and computers who do it legally with elaborate formulas. If you only suspected before, make no mistake, the world of “2 & 20” is loaded with ruthless predators who will do anything “legal” to take our money and put it in their pockets.
Often, its not their money. So if they have to risk a few million dollars to potentially gain tens of millions with a certain tactic, they will.
So where does this leave the small investor trying to make his way legitimately in this war zone?
A few recommendations, none of them startling or new, come to mind:
1. Get automated yourself. To keep up with the information junkies who can turn minutes into millions, we need to get better at using market and company data and news faster. Turn your screens and watchlists into “bargain hunters” and “warning signs” that automatically alert you to stocks and prices where you want to take action.
We won’t see all the blindsides coming. There is a secret world of information passing among a few who want to clobber us and they build their short positions quietly acting on that info. But we can survive the occasional Conn’s (CONN) if we do our homework to win more often.
2. Get serious about risk management. If it seems like the tide has turned against a sector/industry/stock, be ruthless with your own risk control or at least have a plan you can live with. If you prefer not to take short-term gains, make sure you know if doing so would be better in the long run before a 25-50% drawdown comes your way.
For instance, I got shaken out of good growth stocks like Qihoo 360 (QIHU) and Jazz Pharma (JAZZ) last week at levels I didn’t think I would see them near again. But that’s exactly what the pros are counting on: finding our maximum pain to spook us out so they can pick up the best bargains.
3. Never give up being an investor. The stock market may be “rigged” on some levels in certain arenas, but the machines and manipulators do not own the market. It is still a universe of information about thousands of companies where there is always opportunity, be it value or growth (momentum is their game and you better come ready to play hard).
This universe it is dominated by serious investors running trillions of dollars. If we can swim among these whales and take our pieces of the spoils, without getting eaten by the sharks, it’s still the best game on the planet.
This is just a short list to get the conversation going. What’s your advice to beat the machines, stay safe, and grow your capital?