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The Twitter flash crash on Tuesday that very briefly shaved 140 points off the Dow Jones Industrial Average should be of great concern to retail investors.
That short and sudden dip in the markets, caused by a false Tweet on a hacked Associated Press account that suggested President Obama had been injured in a bombing at the White House, was yet another reminder of the risks that high-frequency trading (HFT) poses to the markets, and to retail investors in particular.
Simply put, HFT is the practice of using supercomputers to execute trades in milliseconds.
Because high-frequency trading accounts for at least half of the market, any hiccup in the system can have an instant and dramatic impact, as we saw with the now-infamous flash crash in May 2010 that sliced 1,000 points off the Dow in 10 minutes.
As if that weren't already treacherous enough, HFT firms increasingly have added social media inputs, like Facebook (Nasdaq: FB) and Twitter, to the mix, to scour their feeds for news that could affect stocks.
So now even something as absurd as a fake Tweet can move markets.
"Algorithms used to trade off news headlines, now they trade off tweets. That's very dodgy, very shaky ground," Oli Freeling-Wilkinson, chief executive officer of the London-based analytics firm Knowsis, told Reuters.
How High-Frequency Trading Hurts Retail Investors
"High-frequency trading isn't illegal. But the way it is practiced today, it should be," said Money Morning Capital Waves Strategist Shah Gilani, who noted that HFT just gives the big boys another unfair advantage over other investors.
The HFT computers issue millions of orders a second, but execute only a fraction of those orders. The others are fakes, sent out to see where other traders are willing to buy or sell. The goal is to move the price a fraction of a penny in one direction of the other, which then becomes the trader's profit.
"It isn't illegal. But it is manipulation," Gilani said.
It hardly seems worth the effort. But those fractions, multiplied by millions of trades, add up to billions of dollars.
That money ultimately comes out of the pockets of other traders, including retail investors – even those who don't trade that often.
"It's like people who shoplift. That cost gets passed on to the consumer," Jeff Kilburg, founder and CEO of KKM Financial, told Yahoo Finance's Breakout.
Worse yet, HFT-caused flash crashes can cause significant losses to smart investors who protect themselves with stop-loss orders that automatically sell a stock when it falls below a set price.
"You talk about $200 billion being erased [in the Twitter flash crash], but how much was folks with stops in the market?" Kilburg said. "These [algorithms] really ran the gauntlet and they cleaned out a lot of people. I don't know the percentages, but definitely there was damage done to the ma and pas."
Twitter Flash Crash is a Red Flag for Regulators
Obviously, dealing with the HFT issue is a job for our market regulators – primarily the Securities and Exchange Commission (SEC).
Unfortunately, the SEC did nothing in the wake of the 2010 flash crash and has ignored other evidence of harm to the markets.
So while one would think the Twitter flash crash would get the SEC's attention, history shows that when it comes to HFT the agency is sleeping on the job.
And while the 2010 incident and this week's Twitter flash crash grabbed headlines, small-scale HFT-caused flash crashes are alarmingly common.
Active traders say there are at least a dozen "mini-flash crashes" every day – "mini" because they affect just one stock rather than the whole market.
But the mini flash crashes often affect major stocks such as Apple Inc. (Nasdaq: AAPL) Aon plc (NYSE: AON) and Berkshire Hathaway (NYSE: BRK.A, BRK.B). In fact, Google Inc. (Nasdaq: GOOG) suffered a mini-flash crash on Monday, dropping 3.1% – and recovering – in a matter of seconds.
Kilburg says it wouldn't be that tough to implement rules that would limit the harm that HFT does to the markets, and to small investors.
"How about we charge for each order they enter? Because they enter a million orders in two milliseconds and cancel it. Why don't we charge them some type of fraction on that entry and we'll see how many orders they pull and replace," Kilburg said.
Gilani also has a few suggestions.
"The SEC and all exchanges need to immediately end anybody's exchange access speed advantage that in any way disadvantages anybody else, he said. "No one should be allowed to post fake quotes to manipulate other traders or investors."
Unfortunately, unless the folks at the stock exchanges and the SEC start to show some real concern, HFT will keep hurting retail investors. And the threat of more Twitter flash crashes will just keep growing.
"It'll happen again," Joseph Saluzzi, co-founder of stock brokerage Themis Trading, told the Huffington Post. "It's a matter of when."
Related Articles and News:
- Money Morning:
Unless We Act, High-Frequency Trading Will Crash the Markets
- Money Morning:
The Truth About High Frequency Trading and The Coming Market Crash
- Money Morning:
High-Frequency Trading is a Scam That is Crippling the Markets
- Huffington Post:
Twitter Causes A Flash Crash, Highlighting Market's Structural Problems
Flash Crash Redux! Twitter Hack Triggers Major Warning for Investors
Hoax tweet tests firms that filter social media for Wall Street
- CNN Money:
Mini flash crashes: A dozen a day