Make a list of your favorite and ultra-sturdy stocks — let’s say 3M, Caterpillar, IBM, Apple, Google, Chevron, Coca Cola, Exxon Mobil, Johnson & Johnson, McDonalds, Verizon. Next put in BUY orders at 25%, 50%, and 75% of today’s prices. Make the orders good till canceled, i.e. good forever.<\/p>\n
Remember the Flash Crash of May 6, 2010? I’m convinced it will happen again.<\/p>\n
If your orders are in NOW, you might actually fluke a cheap buy the next time a flash crash happens and make yourself some instant money. I’m guessing the exchanges won’t void all the trades, just like they didn’t do last time.<\/p>\n
First some background. the bulk of today’s daily trading on ALL stock exchanges is done by high frequency trading houses. These places have four “assets.” They’re headed by a successful stock trader. Second, they have a bunch of quants. These are maths and physics Ph.Ds who can program computers with trading algorithms they and their traders figure out.\u00a0 And they have powerful computers and ultra-high speed communications lines. They locate their computers and lines as close as possible to the center of the trading action — e.g. a big exchange.<\/p>\n
Te name of the game in this business is to gain knowledge a milli-second sooner than anyone else. With that knowledge your computers can trade and make a fraction of a penny on the trade. For example, your computer finds one exchange is selling IBM at a penny higher than another. Quickly grab some cheap IBM and quickly sell it on the expensive exchange. That trading strategy is called “latency arbitrage.” Another strategy might to be watch the order books. For example, let’s say I place an order to buy 10,000 IBM. Their computers\u00a0 see my order, check the sell orders around the world (there are few). So it quickly buys IBM, figuring that my order, when it’s executed,\u00a0 will drive the price up a penny or so. That’s a form of front-running, which is illegal. But it’s not illegal, I guess, if your computers and communications links are faster than mine.<\/p>\n
There are millions of other strategies. That’s why you have the quants and the traders. Their job is to identify trading strategies as they change. And change they do.. Their main strategy is to be completely out of the markets by the end of day.<\/p>\n
The business of being a high frequency trading house is immensely profitable. That’s why all the major investment banks have internal high frequency trading shops. The one at Goldman Sachs is one of the biggest. It is not uncommon for these houses to go for months without a single losing day. I repeat: They make money every single day. That is a lot better than you and I.<\/p>\n
All this explains why there has apparently been an explosion of high frequency trading houses. Heck, it’s a lot cheaper and faster to open one of these houses than to build a new steel plant or a car making factory. And you don’t have to worry about consumers’ and their fickle changing tastes.<\/p>\n
You’d think what these guys do would be illegal. Heck, buying in front of my IBM order is called — in some circles — front running. That’s illegal. But doing what the high frequency trading houses do is called “creating liquidity.” And curiously, that’s precisely what many exchanges want for their customers. There’s about 16 exchanges to trade IBM in the U.S. They’re all in competition with each other. Many will actually reward these high frequency trading houses with real cash money for providing that liquidity. So, for example, a high frequency trading house can buy IBM for $144.55 and sell it for $144.55 and actually make a profit. I don’t exactly know how this works. But I’m jealous.<\/p>\n
The problem with high fequency trading houses is that we know so little about them. You and I can see the volumes and transactions on the public exchanges. But there are also non-public exchanges, called variously “dark pools” by the industry. These may\u00a0 be larger than the public exchanges.<\/p>\n
The problem (and the opportunity) in all this is that computers are doing all the trading. And computers screw up. Look what happened to me this morning, when this column blew up.<\/p>\n
There will be another Flash-Crash. The computers belonging to the high frequency trading houses will simply stop. They won’t know what to do. They will be faced with a situation they were trained to deal with. They will freeze and stock prices will plummet. It won’t be long — perhaps a few minutes — just long enough for the humans to jump in and start buying or reboot their computers. But for those few minutes, there will be genuine bargains.<\/p>\n
Yes, but Harry, won’t the exchanges reverse some of the trades in the flash crash?<\/p>\n
Maybe yes, maybe no.<\/p>\n
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