Thursday, September 24, 2009

The Next Bubble?

Is it possible that the next stock market bubble is stock trading itself? Of late some press has been given to practices like flash trading and high frequency trading. Both these mechanisms are dependent on high tech hardware and software and are therefore only available to the larger players – for now at least.

In flash trading, the trader tries to maximize the rebates offered by exchanges by freezing his trade for a fraction of a second by offering to trade rather than responding to the trade. Additionally a flash trader may seek interest in his security from “dark-pools” or electronic exchanges outside the traditional exchanges.

High frequency trading as the name suggests involves the conducting of really fast trades using sophisticated computers and algorithms. Enormous volumes of stock are traded and even minimal swings in the values of these stocks can lead to gains. Some observers say that high frequency trades account for over half the trading volumes in markets these days. Flash trading combined with high frequency trading can lead to even greater profits. A flash trader may for instance see the interest in a stock and use this information to buy the stock to re-sell at high frequency to people who want to buy it. The spreads sometimes are less than a cent. While some have compared this to front running – the illegal practice of using advance knowledge to trade in a stock – loopholes in the regulations in some markets allow this practice.

Both these practices take advantage of the momentum in a stock’s price. Large volume trades can capitalize on even a 1c movement in stock price and eke out substantial profits. In a way this is an extension of day trading and the end goal is to make profits in fractions of a second and get in and get out of a stock making money in as short a time as possible.

In recent months these practices have led to an explosion in the volumes of shares traded. Many companies see many times the volume of the total shares listed which implies a high frequency or flash trading of the shares. These shares are held for fractions of a second only to be re-sold.

This feeble mind wonders how an ordinary investor can capitalize on high frequency trading.
Currently of course a small investor will not have access to these markets. The only way to play this is to be a high net worth individual, one who has money in the accounts of brokers who use these tactics. Chances are though that these mechanisms will be democratized over time allowing smaller players to participate or to pool their resources in order to participate….at their peril.

Obviously the accelerated trading of large volumes for profits may result in the formation of a bubble until some large companies bet too much and lose too much. On the plus side however, the government is already taking steps to investigate this.

One wonders if this is the continuation of the new paradigm for making money. It started in the dot com boom and bust and continued in the real estate bubble. Inherently these bubbles pushed the envelope on making money from nothing but trading be it in dot com stocks or derivatives and instruments tied to real estate. Flash or high frequency trading continues this by trading in micro momentum with scant regard to fundamentals or other historic measures of valuation.

This leads one to almost yearn for the quaint old days of stock swings on quarterly earnings and the maniacal focus of the top executives in meeting the quarterly figures. People complained that a quarterly focus prevented companies from strategizing long term. Now it appears that even a quarter is too far off the horizon and micro seconds are the new unit of measure.

1 comment:

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