Markets Gone Wild? What High Frequency Trading Really Means for Retail Investors

Eric Hunsader knew something was going very wrong as soon as the market opened on Aug. 1, 2012. As the founder of stock market data collection specialist Nanex, Hunsader knows what normal market action looks like. This was anything but.

At 9:35 a.m. EDT, Hunsader tweeted:

Trading exploded, and by 9:38 a.m. there were 14 stocks with trading volume higher than the S&P 500 SPDR (NYSE: SPY  ) . As Hunsader put it in another tweet, "that never happens." The craziness continued, trading volumes continued to climb, and prices of some stocks swung wildly for no apparent reason. At 9:39 a.m., Hunsader fired off another tweet:

No halt ensued. At 9:55 a.m. the wild trading had still not let up and Hunsader lamented:

The computer systems at Knight Capital (NYSE: KCG  ) had apparently taken on a mind of their own, erratically trading massive volumes of 140 different stocks. For nearly 45 minutes, Knight's systems blasted away, leading to $440 million in losses -- or roughly $10 million per minute of out-of-control trading. The losses crippled the company's balance sheet and, just like that, put one of the world's largest trading firms on the edge of extinction.

Jason Zweig at The Wall Street Journal and The New York Times' Joe Nocera were quick to characterize the turmoil as one more reason for investors to throw up their hands in disgust and exit the stock market completely. They were joined by numerous others, from Financial Times to Fox Business. If you subscribed to the prevailing view, you'd easily conclude that Knight's failure was a sign of a market completely out of control, and, furthermore, that it was a reason for individual investors to lose their last shred of faith in stock markets.

The apparently obvious conclusion isn't always the right conclusion, however. The trading glitch at Knight Capital did indeed represent failure on a massive scale. But this was a very different kind of breakdown than many of the other failures in recent memory, including the stomach-wrenching "flash crash" of 2010. As Ron Kruszewski, the CEO of eventual Knight investor Stifel Financial (NYSE: SF  ) put it to us:

This event was different than the Flash Crash. ... The market worked. Capitalism worked. Knight took their loss. I can guarantee you that every firm that has computer interaction, including ours, did a thorough review of their system. In many ways, the market was a good regulator here. Knight was not the Flash Crash. That's very important to understand.

Nevertheless, watching one of the largest market makers nearly go out of business thanks to a computer glitch knocked many investors -- professional and retail alike -- back on their heels. Are unpredictable computer algorithms an inevitable part of the brave new world of investing? Do retail investors need to take special precautions in order to participate in today's stock markets?

Though "the market" may have done well in meting out punishment in the case of Knight Capital, this event highlights the need for investors to have an understanding of the structure of modern stock markets. In the series that follows, we take a closer look at the intricate plumbing of modern stock markets, while also highlighting some of the dangers that investors face. Throughout these articles, we'll suggest strategies that investors might use to protect their portfolio from risks associated with high-speed trading.

Of course, in order to really understand what went on, it's best that we begin at the beginning.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook.

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Read/Post Comments (23) | Recommend This Article (57)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2012, at 5:49 PM, jlnowling wrote:

    Great story,

    I'm very happy for Knight, I hope they go down! HFT's have been giving the stock market a bad name for years. Poetic justice

  • Report this Comment On September 14, 2012, at 5:53 PM, Big50Shooter wrote:

    How does that line from the old Queen song go?

    Oh yea:

    "We're just waiting for the hammer to fall"...

    The market is essentially controlled by the big-investment banks, their trading algorithms and their access to "free money" at the Fed. discount window....

    Look at the trading activity in the last couple of years and tell me I'm wrong....

  • Report this Comment On September 14, 2012, at 6:02 PM, hank321 wrote:

    This issue goes to the heart of the difference between an investor and a trader. HF challenges small traders; but investors such as myself, with a 6-60 month horizon,....need be less concerned.

  • Report this Comment On September 14, 2012, at 7:22 PM, lowmaple wrote:

    I have long hoped that one of my ridiculously low bid would be filled by one of these "disasters" no luck yet. For investors with limit orders these are gifts.

  • Report this Comment On September 14, 2012, at 8:05 PM, Seanickson wrote:

    agreed, I wasnt bothered much by the movements of August 1st. However, I do have a 500 month horizon.

  • Report this Comment On September 14, 2012, at 8:38 PM, ChattyPatty wrote:

    Once again, the SEC is the tool of investments firms -- they can't even get a conversation going about whether to restrict (highly improbable) or even ban HFT. Meanwhile, European regulators are addressing the problem headon (see: http://blogs.wsj.com/marketbeat/2012/08/15/foreign-regulator.... A while ago 60 Minutes interviewed one HFT who said they had not had any losses in five years. How is that possible??? Well, proximity to an exchange adds nanoseconds of trading edge, and algorithms provide advantages that hard work and research on an individual investor's part can't match -- essentially, it's cheating. I think HFT should be banned, period. But with our lackeys in Congress and the SEC, it's not likely to happen.

  • Report this Comment On September 14, 2012, at 8:44 PM, bigcg98 wrote:

    You underplay the potential impact of predatory algorithms. Just because the last "Flash Crash" didn't hurt the individual, doesn't mean the next will be the same. Also, Nanex themselves will tell you that there are indeed firms that employ predatory tactics in conjunction with HFT,(see Hunsaker's interview on Jim Puplava's Financial Sense web site) and that the SEC has no interest in investigating and/or penalizing any firms that use such tactics for whatever reason. I leave that to the investor to speculate about but its not unheard of for regulators in many areas of public and private life to conveniently "look the other way" when they themselves are on the dole in one way or another. Motley Fool is trying to sell us on the tired old "buy and hold" strategy that cost many from 40-50% of their retirement protfolios during the housing meltdown of 2008, because it keeps them in business. Fact is, more money can be maid by trading short/intermediate term if there weren't the manipulations going on by companies making billions off of HFT and the abusive practices that accompany them.

  • Report this Comment On September 14, 2012, at 9:24 PM, ccrashcup wrote:

    You cannot name me one instance where the HFT's are good for the market O/T the mega firms themselves. So why i it allowed? I think we all know the answer...politicians

  • Report this Comment On September 14, 2012, at 9:29 PM, phexac wrote:

    Nowadays when you buy the stock, the bid-ask spread is a penny wide. Before high frequency trading, it would have been a lot more. Which do you prefer?

  • Report this Comment On September 14, 2012, at 10:45 PM, BMFPitt wrote:

    For real investors, HFT has no effect.

  • Report this Comment On September 14, 2012, at 11:27 PM, JadedFoolalex wrote:

    To paraphrase Blue Oyster Cult's song Godzilla...

    "History shows again and again how technology points up the folly of men"

    HFT damages traders NOT Investors!!! When HFTing hurts the SEC itself, you'll then see them do something to control this. Until then, those of us who invest couldn't care less! As Warren Buffet says "Invest in such a way so that you would be comfortable if the market were to be shut down for 10 years!" That means "Buy and Hold"! So investing in so-so and iffy stocks does not make for comfort, does it, bigcg98?

    As for the statement that one HF trader has not lost in 5 years, I call "BS"! They paid fees! They paid taxes!! They paid rents!!! Don't tell me they didn't lose!! We all lose!! Hello!!!!!

  • Report this Comment On September 15, 2012, at 1:09 AM, dgmennie wrote:

    It has already been reported in Fool postings elsewhere that "more than 60% of total [trading] volume is [now] being done by high-frequency computer trading...." Yes, the algorithms have taken over and they are not there to assist the small independent investor. In fact, the time is fast approaching when there will be no significant number of small investors left in the game, and "investing" will simply be an endless contest between major players using competing algorithms that seek to avoid any short-term risk. Should enough trading volume move in ONE direction at exactly the same time, the markets will swing wildly up or down, inspired by who-knows-what rumor/newsbite. Meanwhile, the average investor's IRA or brokerage account will always face great peril in this environment. These non-professionals only serve as much-needed market fodder. In fact, those traders who claim they "never have a loss" may indeed be correct. They can do this by moving huge amounts of money in milliseconds using predictive encoding. So long as their algorithm is faster/smarter than the competitor's, they can profit on every small market shift, simply because they "know what's coming" before anyone else does. Do this enough times correctly every week and you have a goldmine that produces unending profits regardless of the prevailing economy. One guess as to who is paying the piper.

  • Report this Comment On September 15, 2012, at 7:22 AM, nivekluap wrote:

    Dear Motley Fool,

    Please keep selling me on the buy and hold method of investing. Through some of your reccomendations and my intestinal fortitude, I'm up 34% year over year since Jan., 2008. It's even better looking since 2009 when the real blood was in the streets.

    KD

  • Report this Comment On September 15, 2012, at 9:31 AM, daveandrae wrote:

    High frequency trading is the very essence of Noise. No reasonably intelligent investor in his right mind takes the day to day, or even the month to month price swings of his securities seriously.

    Daily price quotes gives the serious investor a basic advantage in that he can, if he so chooses, add to his positions when his securities are quoted below fair value, and refrain from adding to his securities when they are quoted above fair value.

    The investor that allows the "market" to influence his thinking by such meaningless jargon as "high frequency trading" is turning a basic advantage into a basic disadvantage. These poor souls would be better off if their securities were not quoted at all!

    The stock market is not a preceptor. You shouldn't be interested in what it "thinks." Rather, the stock market is no different than a grocery store in that the only thing an investor should be interested in, is the price the market is quoting him.

    If you think the market is smarter than you, that's fine. Give it your money via an index fund. People do it all of the time and have done very, well, over the long run.

  • Report this Comment On September 15, 2012, at 12:05 PM, alexanderantonio wrote:

    The more HFT the better, why? If you have say six huge players on Wall Street and they all use HFT and they all want to make money, what happens? Stock prices go up! What happens when the trades these few computers make encompasses an extremely large percent of trades? Stocks go up! These computers don't make money when stocks drop, they make money when they go up.

    So the fact that Knight capitol lost money is actually inherently beneficial.

    If joe is trading in a pool of ten dollars with Ron and Susy and he loses 4 dollars in this finite pool: inherently either Susy or Ron make that money he lost.

    These HF machines are actually really helpful in that they causes stock prices to rise, and when they go rogue the only people who they're screwing over is themselves.

  • Report this Comment On September 15, 2012, at 12:16 PM, ravens9111 wrote:

    Although Knight Capital took the loses, so did many retail investors. I would think "most" retail investors had a stop loss in place. Did it trigger? I bet you it did. Were retail investors quick or smart enough to buy those cheap shares? Probably not. Most likely they came home from work to check their statement only to see they got stopped out. All the profit from those stocks wiped out or even a sizable loss. I don't blame retail investors that leave the market. Finding a trusted financial planner that can guarantee you specific rate per year plus get additional upside in a good market is a solid conservative strategy. Most will even give you an additional 10% up-front bonus. Just make sure you find the right one. The stock market these days is not for the faint of heart. If you don't want to risk your money, go the conservative approach and get a guaranteed return every year.

  • Report this Comment On September 15, 2012, at 12:34 PM, daveandrae wrote:

    ^

    "I would think "most" retail investors had a stop loss in place."

    This is one of the most oxy-moronic statements I've ever read.

    Harley Davidson was one the stocks that fluctuated wildly that day. ( I know because I own it). Yet, as of September 15th, 2012, the year over year total return on HOG stock is well over 18%. Thus, not only have most "retail" HOG investors forgotten about that day, they don't even remember it.

    Show me a "retail" investor that uses a "stop loss" and I'll show you a person that is guaranteeing himself a permanent loss of investment capital. The simple truth of the matter is that "retail" investors that use "stop losses" are not retail investors at all!

    Anyone that tries to wish away the price volatility of a stock by using a "stop loss" is also wishing away the return of the stock. You cannot have one without the other. It's a package deal.

    Put simply, if you're not willing to let the security fluctuate after you purchase it, then do yourself a huge favor and don't buy it all!

  • Report this Comment On September 15, 2012, at 12:48 PM, Pandorabelle wrote:

    It's unfortunate that even the most seasoned investors don't fully grasp the scope complexities of HFT algos and the way they are used/abused---and that's the way the MM's like it! They are designed to fake-out, trap, and swoop in to capture profit - in BOTH directions - in nano seconds. A "glitch" - by accident or design - has the potential to devastate small retail if it triggers selling and stops.

    Even IF authorities fully grasped the implications, they are extraordinarily difficult to track, much less regulate, due to speed and volume---even IF you could get a regulator to pay attention, instead of being paid to look the other way.

    One of the most insidious uses of the algos is in "dark pool" trading - a practice that is shrouded in secrecy where, among other nefarious practices, they have been used to skim the skim on fees in peoples' 401K's for years--without the 401K member ever knowing! I want to know why no one discusses the details of this issue, much less demands that it be banned. And the new open-ended QE that spells death to the US dollar only proves that Ben is loyal to the market, not the public. No wonder small retail is flipping the market/casino the bird.

    The bottom line is that they give big money and unfair advantage in a market that is no longer free. When the casino is rigged, people stop coming.

  • Report this Comment On September 17, 2012, at 9:11 AM, jargonific wrote:

    The newest high speed trade systems are operating in more like warp speed compared to what any of us can do as individual traders. Yet we must compete with them somehow or risk losing or staying flat without a profit. So what is there to do? The answer is absolutely obvious. Ban High Speed Trade immediately and let the markets correct down finally. Let people know that its happening and let everyone take a loss that is manageable over about 6 months time. In other words, a controlled down turn. People who are "in the know" will struggle just like everybody else to find the right positions back into the market, they won't be able to push markets around with short sells that take place in fractions of seconds. They won't also be able to move things dominantly, and will have to allow the actual values to dictate markets rather than HST computers moving them. It will hurt temporarily, but help over the decades. If this doesn't happen, as major EU leaders knew it should happen months ago, the markets will continue to run in the hands of the tiny minority and both individual savers, traders, and retirees, will be the victims of markets... governments will be at the mercy of hedge funds and high speed trade computer managers. That's where we are right now. Democracy can't work in this climate, and it isn't working.

  • Report this Comment On September 17, 2012, at 9:31 AM, ravenesque wrote:
  • Report this Comment On September 17, 2012, at 11:39 AM, digitaltrading wrote:

    Very nice information for traders, thanks for the article and congratulations for your blog, the markets are really gone wild in this times

  • Report this Comment On September 27, 2012, at 3:31 AM, thidmark wrote:

    "Motley Fool is trying to sell us on the tired old "buy and hold" strategy that cost many from 40-50% of their retirement protfolios during the housing meltdown of 2008 .. "

    This is nonsense. Even If you bought at the 2007 market top and held, you would have only a slight loss today. Nowhere near 40-50 percent.

  • Report this Comment On September 27, 2012, at 3:40 AM, thidmark wrote:

    "When the casino is rigged, people stop coming."

    Another gem.

    Casinos ARE rigged, based on the laws of chance and probability. The house always wins.

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