The prevalence of computer-generated trading in the modern sharemarket has created an unpredictable, and sometimes dangerous, environment for investors, writes David Potts.
The prevalence of computer-generated trading in the modern sharemarket has created an unpredictable, and sometimes dangerous, environment for investors, writes David Potts. Robots don't have to take over the world when they've got sharemarkets in their clutches already.Unlike a mere mortal trading, there isn't even a broker between machine and, well, machine. All that stands between them is a fee the Australian Stock Exchange collects.Self-automated algorithms can generate 150 trades in the blink of an eye and, unlike ordinary investors or even the big funds, have been given the ultimate privilege of plugging straight into the ASX's computer. They're the ultimate inside traders.Since the one-minute massacre of QBE Insurance more than two years ago by a rogue robotic trading program, all that has changed is that now it would take a mere millisecond. And it wouldn't stop at one stock.The share price was savaged from $15.70 to less than a cent before anybody could do anything.An even scarier incident recently on Wall Street, where price swings have become increasingly wilder, showed what the automated computer programs that drive most of its trading can do.Knight Capital Group's computer went berserk, blowing $440 million in an hour and made a mockery of the prices of 150 stocks.So entrenched has speed trading become on Wall Street and in most of Europe that, in this globalised world, Australia's regulators haven't so much gone along with it as only suddenly realised what's crept up on them.In any case, the ASX is compromised because it let the computers into its data room in the first place, lured by the prospect of fees on tiny - but relentlessly frequent - trades.SURVIVAL OF THE QUICKESTSpeed-trading computers sit next to an exchange's to minimise the millisecond it takes for data to go down a fibre cable. The whole point is they have to get in first.The problem for punters who must use a broker, along with super funds and everybody else except the owners of the algorithms, is that the computers queue-jump.They have an unnatural advantage in seeing an order before brokers do.Think that's bad? Try this: ASX announcements and news wires such as Bloomberg are fed straight into the algorithms. They can read, digest and act on the information infinitely faster than you.Bet you aren't sent a profit downgrade straight to your computer from the ASX the moment it's announced. Thought not.But imagine the advantage a robo-trader would have in knowing before you.That used to be called insider trading. Now it's "liquidity enhancement" and it's legit.A variation on this is a tactic employed overseas, and possibly already tried here given the glitches the ASX system has periodically, which is swamping the exchange's computer with multiple single-share orders to slow down the system.That can give the computers a few extra seconds to act, or jump ahead of any trades that had been frozen.Often you'll see trades of a single share where the brokerage costs more than the stock. The computer is sussing out prices, forcing you to pay more - or get less if you're selling - than what your online broker's screen says.Talk about unfair or, in finance speak, an uneven playing field. No wonder the corporate watchdog, the Australian Securities and Investments Commission (ASIC), is having doubts, except, like everybody else, it isn't too sure exactly what the computers are up to.They can run rampant with a faulty algorithm until somebody pulls the plug, but not before the market has been shaken and confidence drained from it.Either they're undercutting a seller or overbidding a buyer to get in first, beating you to the punch even at your price.ROBO-TRICKSWorse still is flooding the market with fake bids, suggesting something's happening and there's momentum, only to cancel them a nanosecond before the market opens. Once, that was considered market manipulation.Regulators around the world have been duped by speed-trading proponents, invariably stating that it "adds liquidity", which aids what has come to be called "price discovery".The true price of a stock is revealed because, thanks to the computers trading with each other, there are more trades and depth in the market.Whether there's extra liquidity is debatable. It's not as if the sharemarket has unusually high turnover as we speak.In fact there's very little, a worry in itself."Volumes are very low," says an equities analyst at Bell Direct, Julia Lee."Imagine what they'd be like without high-frequency trading."The trouble is that to escape the manipulative grasp of the computers, brokers are shifting away from the ASX into private exchanges known as dark pools because they aren't transparent. Speed trading has pushed up to 43 per cent of trades into them.You have to laugh. The liquidity supposedly created by speed trading is drained into dark pools, leaving the official sharemarket no better and probably worse off.As the GFC showed, liquidity is never around when you want it. And the robots run away first.Even in normal times, speed traders put in multiple bids that are never executed.One of the top-performing fund managers, John Abernethy of Clime Investment Management, will have none of it."What's price discovery? It's an invented term. It's just tripe," he says."High-frequency trading should be banned until the benefits can be proved. It can't be backed up with facts. From what I can see, it doesn't create liquidity, it destroys it."The price of a single share traded sure isn't going to tell you much. All it does is lift the cost of buying or selling shares."If you're not watching the market all day, you can put in an order for 10,000 shares and get just two, which we would never buy if that's what was on offer," Abernethy says.Having inadvertently paid brokerage on a solitary share, you can hardly turn around and sell it, because you'd be out of pocket a second time."You end up paying more to get a decent parcel," Abernethy says.Although the problem of automated trading is the gap between man and machine, ASIC's remedy, apart from talking about a circuit breaker, is to insert another computer into the equation. It would detect any tricks its robotic relatives were up to. Guess if you can't beat 'em, join 'em.TIPS FOR HUMANSSo what can you do, short of avoiding the market altogether?For starters, never submit an "at market" buy or sell order to your broker. You're playing right into the computer's hands - er, hard drive.Otherwise you could end up with one worthless stock because you'd finish up out of pocket selling it.Counter-intuitive as it sounds, also avoid mining stocks that have high turnover. Since computers get in first, you're only speculating against yourself. Speed trading can bash them around with no trouble at all.And think twice about short-term trading. Robotic trading produces spikes or dips in prices that can easily be mistaken for the start of a trend.To the extent speed traders dominate trading, a stock can stay fundamentally out of whack for a long time."They make the market much more volatile and unpredictable," says Dale Gillham, the chief analyst at fund manager Wealth Within, which runs the only accredited diploma of share trading and investment. "It's like a marathon race. Someone sprints for 10 minutes and gets out in front but the pack catches up."The whole idea of speed trading is to catch you out, so the solution is to "look at the bigger picture", he says."Don't trade day by day. Look at the market on a monthly basis and say - what is the real trend?"Another way of avoiding market manipulation is investing in an unlisted index or an exchange-traded fund.These track the whole market, or part of it depending on the fund, and so whatever manipulation is going on should come out in the wash.But don't hold me to it.ROBOTS ON THE RAMPAGEIn the Flash Crash, the US Dow Jones Industrial Average plunged 1000 points in 20 minutes, destabilising markets around the world. It quickly shoots back up.Shares of blue-chip QBE Insurance, a favourite of super funds, crash from $15.70 to less than 1? in about a minute. The trades are cancelled.More than 16.6 million shares of FKP Property Group are traded at 40? each. The stock's typical daily volume is only 2 million. The incident was captured on YouTube before it was reversed.Knight Capital Group in the US lost $440 million when an automated trade went horribly wrong, sucking 150 stocks into the vortex.On Tuesday, there were four trades of one share in BC Iron at 11.16am at $2.65 each. At 11.20, the price surged to $4.64 in a nanosecond for no reason. Five minutes later, the ASX suspended trading for two minutes, then allowed the trades. The stock immediately dropped to $2.65.SEVEN WAYS TO BEAT SPEED TRADINGBuy only quality stocks, and for the long term.Track your order or you risk buying or selling just a single share or two.Avoid high-volume mining stocks.Consider lower-volume smaller stocks.Buy an index fund instead.Don't be fooled by big price swings in a day they mean nothing any more.Dollar-cost average when buying to avoid price swings.Volatility all the rage for fashionable managersRATHER than avoiding the spills and thrills of the sharemarket, there's one way of embracing them.You can hitch a ride on the market volatility that automated computer-program trading generates.While you need to avoid specific stocks, lest you find yourself on the wrong end of an algorithm, you can punt on the market bouncing up and down which isn't exactly a tough call.Fund manager van Eyk is so taken by the market's volatility that it's made it a separate investment, like gold or shares."This new fund treats volatility itself as an asset class," the van Eyk chief executive Mark Thomas says.It uses options, which are volatile themselves, over the Chicago Board Options Exchange (CBOE) volatility index, but you have to invest at least $500,000.For a more modest $25,000 you'll get into the Blueprint Alternatives Fund.Unless you treat volatility as an end in itself, it's a "silent killer" of investment returns, he says, because "it reduces the power of compounding. The smoother the return stream from month to month and from year to year, the higher the final return."The CBOE volatility index is also behind a series of warrants with a built-in stop-loss price sold by brokers RBS Morgan.A major difference is these use futures contracts. They're also geared, which magnifies the risk, and so are strictly short-term investments.Bet they'll show those robotic computers a thing or two, though.
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free