When the Dow crashed 514 points last August 8, the market lost $850 billion in market capitalization. High frequency
(HF) traders were probably responsible for half of this move, but booked only $65 million in profits, 0.00007 of
the total markets’ loss.
The carnage the HF traders are causing is triggering a rising cry from market participants to ban the strategy.
Many are calling for the return of the “short sale test tick rule”, or SEC Rule 17 CFR 240.10a-1, otherwise known
as the uptick rule, which permits traders to execute short sales only if the previous trade caused an uptick in prices.
The rule was created eons ago to prevent the sort of cascading, snowballing of selling that we are seeing today. It was
repealed on July 6, 2007. The volatility has been high since 2007.
If you pull up a VIX chart back to 2007 you can clearly see that VIX has never returned to the levels we dealt with when
the uptick rule was in effect.
Those unfamiliar with how High Frequency, algorithmic trading works see it as something like illegal front running. Because
they’re allowed to connect directly into the electronic markets via co-location of their mainframes with the exchanges’
computers (or having them in adjacent rooms), they get a head start over the rest of the traders.
Much of the trading sees HF traders battling each other, and involves what used to be called spoofing:
the placing of large, out of the market orders with no intention of execution.
Needless to say, if you or I tried any of these tricks, the SEC would shut us down (and maybe lock us up), so fast it would make
your head spin.
Many accuse exchange authorities of a conflict of interest, allowing members to reap size-able fees from HF traders, while
the rest of us get taken to the cleaners. Co-location fees run in the hundreds of thousands of dollars per customer. This is
happening while traditional revenue sources, like proprietary trading, are disappearing, thanks to Dodd-Frank.
There is little doubt that the volatility is driving the retail investor from the market. August 2011 saw the highest equity mutual
fund redemption’s in history. But it also makes it easier for us small personal account traders to go short, thereby increasing the opportunities we have to make money in wildly swinging markets. As my members know I have no problem going short.
High Frequency trading has been around since the late nineties, back when the uptick rule was still in place and co-location was unknown. But it was confined to a few niche players and lacked the wherewithal to create 500+ point market swings.
The big problem bringing back the uptick rule now is that HF trading currently accounts for up to 70 percent of the daily trading volume. Ban them, and market volatility should shrink to double digit trading ranges. The exchanges will see massive shrinkage in their transactional incomes and TV financial shows will find something else to focus on.
The diminished liquidity might make it difficult for the 800 pound gorillas of the market, like Fidelity and Calpers, to execute trades, further scaring retail investors away from equities. Is it possible that we have become so addicted to the crack cocaine of volatility that the HF traders provide that we can’t live without it?
By: Big A
Tags: August 8, Carnage, Cfr, Co Location, Conflict Of Interest, Dodd, Electronic Markets, Eons, Head Start, High Frequency, Location Fees, Mainframes, Market Capitalization, Market Participants, Proprietary Trading, Revenue Sources, Sec Rule, Snowballing, Uptick Rule, Volatility
