How Retail Traders are Becoming Collateral Damage

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By Barbara Cohen
Chief Information Officer, ShadowTraders 

 

In the film, Collateral Damage, a bomb is detonated killing nine people in the Colombian Consulate building plaza in Los Angeles. Among those killed are the wife and son of LAFD firefighter, Gordon Brewer (Arnold Schwarzenegger). They just happen to be in the wrong place at the wrong time. They were collateral damage, incidental to the intended target during the attack. Today, trading has become a similar war zone, with retail buyers and sellers being offered up as sacrificial collateral.

For those of you unfamiliar with the daily battles being waged, here's the Reader's Digest version...

High Frequency Trading robot algorithms controlling the order flow of the exchanges are taking out retail traders at the knees.

High-frequency trading robots (HFTs) are complex computerized algorithms used to trade Equity Markets, Futures Markets, even the Options Markets. They analyze data and transact orders in massive quantity at lightning speeds. Large brokerages and hedge funds have made agreements with the major Exchanges, allowing their computers to be positioned inside the Exchanges and hard-wired to the Exchanges' data feed. This enables them to buy and sell within milliseconds.

Today, HFT trades account for over 70% of the daily volume, nearly three-quarters of all trades. And the average time a stock investment is held these days is 22 seconds. Human beings can’t even process the information they are watching on their screens in that amount of time, make a decision and then execute. How are we to complete?

To show how prevalent HFTs are...on March 20, 2012, Goldman Sachs announced that they were laying off more staff to be replaced with robotic technology. The new layoffs will take place across all of Goldman's main divisions: Sales and Trading, Investment Banking, Wealth Management, and Investing and Lending. Human oversight and intervention in decision making will be a thing of the past. Welcome to the future.

This story gets worse and you need to understand why. HFTs create real problems for retail buyers and sellers because they undermine investment legitimacy by "layering" their trades. Layering is where robotic algorithms OFFER to buy or sell large numbers of securities that they have no intention of executing. As the price of the security approaches their offers, these robotic algorithms immediately cancel. But it moves the price.

Retail traders live and die by what is known as "Level II," the quote system used by the NASDAQ, NYSE, and CME Exchanges to provide a real-time "depth" of offers to buy and sell at various different prices.

Level II shows Bids (offers to purchase) arranged in price order from the highest price someone is willing to pay for a security, to the lowest price. Level II also shows Asks (offers to sell) arranged from the lowest price someone is willing to sell their security for, to the highest price.

Buyers and sellers use Level II as a deciding factor in placing a trade or just sitting on their hands because it shows their security's liquidity. Lots of shares / contracts at each price level show a heavily traded market, and a good time for entering their trades. Conversely, a "thinly" traded market, with few shares / contracts waiting to execute is a market they want to stay away from.

Because of Layering, the Level II price ladder that day-traders rely on may no longer be trustworthy. Shares / contracts appear ready to trade at different prices but in fact, those offers are cancelled before the price is ever hit. Retail traders are stuck making flawed decisions based upon phantom, vanishing offers to buy or sell. Layering misrepresents market depth and disguises the actual prices being traded.

For example, a stock is trading at $50/share. The Level II ladder ask side displays lots of shares waiting to execute at $50.01, $50.02, $50.03, $50.04, and especially $50.05.

A retail trader, seeing the ladder, makes an offer to buy at $50, thinking that there really are sellers at these higher levels and that the equity has a lot of price action. Their trade is filled. But almost immediately, the Level II offers to sell at these higher prices literally evaporate because they were phony to begin with. Suddenly the retail trader has difficulty closing out his trade and ends up taking a loss...becoming collateral damage.

The sad part is, while Arnold Schwarzenegger may be able to "get revenge," most retail customers will just be collateral. There are ways to protect yourself against this kind of disaster.

 

Join us Tuesday evening April 3rd at 8:00 pm EST for a FREE Live Trading Event to see how we do it.

 

 



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Futures , Stocks

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Barbara Cohen

Barbara Cohen

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