Unfair Advatage? Is the Game Rigged?

Part 1

I’m not sure but I would hazard a guess that since there have been opportunities to invest in something [exploration/research (i.e. Chris Columbus – West Indies expedition, Oil & mineral exploration), land, railroads, governments (i.e. deeds/trusts, stocks, bonds)] there have been instances where someone has figured out a way to or been accused of exploiting the opportunity unfairly to their advantage.  I’m probably not going out on a limb here.  Given the advance of technology it was only a matter of time before the automation of the stock market ala NASDAQ and eventually the rest of the exchanges (NYSE, AMEX, CBOE, etc.) led to the same opportunities.

I recently watched a news report on High-frequency trading.  What’s that you say?  Let me explain.

On May 6, 2010 the DJIA dropped nearly 1000 points in just a few minutes in reaction to a large sell order placed (accidentally or not doesn’t really matter if you think about it) by a trading firm causing a daisy chain reaction by other firms pre-programmed responses to market moves.  This then caused the initiating firms computer to accelerate its sell orders as it saw the volume of that security’s trades increasing  (without regard to its price) to relieve itself of the falling security faster than a  fund manager would traditionally do “manually” say over a few hours, days or weeks.  This slower procedure they practice routinely to prevent large fluctuations in price of the security they’re trying to unload specifically to a lower price than they could get if they did it slowly and preferably under the radar.  But I’m getting ahead of myself; let me set the stage.

Since computers have come to make mundane manual processes inefficient and obsolete they now have become the backbone of our modern stock exchanges.  Today very few “trades” are actually handled by the traditional “trader” working on the floor of an exchange.  Instead computers do all the heavy lifting and the career of being a “trader” has almost become extinct.  Computers have shrunk from the size of buildings to where they now fit in our pockets.  The speed of processors (CPU’s) continually eclipses previous models.  Memory capacity and speed (both RAM & hard disk drives) continually grows while shrinking in size and price.  The network infrastructure (aka: telecomm network, grid, world wide web) has advanced from copper wires strung on poles across the country to global fiber optic networks which currently bring a 15MBPS down and 5MBPS upload speed to my home (remember that 28.8k modem?).  This has created an incredible opportunity for “innovation” and manipulation of today’s trading systems.  Quants or quantitative analysts crunch algorithms (intricate math formulas) which are able to analyze just about any metric you desire from how often a stock trades, how it reacts to rally’s or declines, in election years, on rainy or sunny days, in leap years and on and on.  As a result they can pretty accurately predict the short term action (reaction) to a market event by a security or index they are monitoring.  Of course given the efficiency of computers they do this for many stocks simultaneously and by “short term” I don’t mean a trading week or day or even hour we’re talking fractions of a second.  Yes, I said second you know 1/60th of a minute.

So if you have this information and you can not only identify an “event” but predict the most likely response of a particular stock (or even better multiple stocks) and then get in and out of that stock (or option) at a fraction of that fraction of a second quicker than the next guy you could make a pretty nice little profit.  Imagine this.  Picture yourself walking towards the bakery counter to pick up your favorite pie.  The baker sees you coming so he’s standing there with your pie in his hands ready to give it to you for 99 cents.  As you near the counter and reach out your hands I come flying in, push the baker out of the way (which is no small feat for a skinny guy like me if you’ve seen most good Bakers – as a rule don’t buy from a skinny baker) putting 99 cents into his pocket and grabbing the pie with my other hand I put it in yours and now take $1 from you because I know I can get it and more people have come in and are walking towards the counter to buy pies.  That is a simplified explanation but captures the essence of the practice.

— Check back soon for part two.

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