What Wall Street Is Desperately Trying to Hide About These Wild Markets

Editor's Note: You can take down extraordinary gains when you understand how Wall Street really works. Shah's been on the inside, and in his free, twice-weekly Wall Street Insights & Indictments, he reveals how to trade the bigger picture for maximum returns. To get his insight and start beating the Street, just click here.

If you think the Dow crashing 1,600 points intraday is unprecedented, you're wrong.

If you think the Dow trading 5,000 points up and down in a single day was an aberration, you're wrong.

If you think the wild swings equity markets are experiencing will eventually pass, you're wrong.

Everything you've heard on TV and everything you've read about the stock market's violent moves this past week is wrong.

What's really wrong is how hardly anyone knows what's wrong, and the handful of people who do know aren't being honest.

I'm going to tell you something you aren't going to hear or read anywhere else: the truth about what's wrong with stock markets, how they got to be so dangerous, and how to trade this new reality.

What I Didn't Say on National Television, I'm Saying Here

As a regular guest on FOX Business Network's "Varney & Co." and "Making Money with Charles Payne," I was asked to appear several times this week.

I was asked to help make sense of crashing markets, the wild swings, and was asked, as a long-term bull, if I was buying this "dip." I'm not.

On Tuesday I was on "Varney & Co." and appeared with the president of the NYSE Group, Thomas Farley.

When host Stuart Varney asked Mr. Farley if there were any problems at the exchange, he replied, things were "working well," and that, despite how wild Monday was, it was an "orderly day" because no limit up or limit down circuit breakers were triggered. It's true that the limit circuit breakers weren't triggered, but that's only because they kick in on a huge 7% down move in the S&P 500.

Then Stuart Varney asked Mr. Farley if the 1,000-point drop on Monday was program trading or algorithm-driven. Mr. Farley completely punted, saying, "The last day I recall with volatility that looked like that was actually the election night... If you look back to the election night and you look at where we are now, the Dow's up 40%, unemployment is down 1%, GDP is up 1%... Markets go up, markets go down. "

So, he didn't answer the question. For good reasons.

It was only out of respect that I didn't dispute Mr. Farley's contention that the sell-off was orderly on live television or his stance that program and algorithmic trading wasn't a huge part of the sell-off and was feeding volatility.

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What I wanted to do was ask him to tell "Varney & Co." viewers why the venerable NYSE lets high-frequency traders co-locate their servers next to the exchange's servers. I know that it's so they can front-run investors' orders by reading them before they get constructed into the national best bid and offer (NBBO), but the NYSE doesn't want the public to know that. I also wanted to ask him what the exchange was going to do to prevent 1,000-point swings tomorrow, or any day in the future they're possible. And what about 2,000-point swings, or 5,000-point swings?

Instead, I started to explain what I'm fully explaining here, only to be "frozen" when the feed from the Sarasota, Fla., studio I was broadcasting from was interrupted by a cable issue in my studio.

The truth is that volatility isn't causing markets to drop a thousand points in a matter of minutes, or causing the wild swings back up and then down again.

Far more frighteningly, the wild swings are a function of the market's mechanics.

Call It the Rise of the Machines

The New York Stock Exchange isn't solely to blame. All the exchanges and all trading venues - which are all electronic, despite the human traders in colorful jackets you see on TV - are to blame.

The rise of the machines is a function of competing exchanges and trading venues vying for orders, employing better-faster computers and new technologies. And the lack of honest liquidity is a function of "decimalization," which feeds the machines like blue whales feed on krill.

I'll get to that. First, about those "exchanges."

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The NYSE and, later, the AMEX (American Stock Exchange) used to be the principal locations where stocks were traded in the United States. Both are in downtown Manhattan. In 1971, Nasdaq (National Association of Securities Dealers Automated Quotations) was launched to trade OTC stocks (over the counter, meaning not listed on the NYSE or AMEX) via computer terminals.

For years, everyone kept to their turf. But the end of fixed commissions in 1975, the proliferation of computers in the 1980s, the Internet, discount brokerages, and the individuals and small traders who wanted to trade spawned trading venue competition.

In the late 1990s, electronic communications networks (ECNs), computerized trading platforms, with names like Archipelago and Brut, wanted to trade NYSE stocks, AMEX stocks, Nasdaq stocks, and anyone's stocks their public customers wanted to trade. They won the right to do just that. ECNs proliferated like wildfires in the face of Santa Ana winds.

The problem with multiple trading venues (now including exchanges like Direct Edge, BATS, and dark pools) all trading the same stocks is that orders to buy and sell the same stocks get spread all over the place, as opposed to all going to one location.

Back when an investor or institution wanted to buy or sell a million shares of IBM, they sent their orders to the NYSE, where everybody's orders from around the world went.

The "specialist" at the NYSE in charge of trading IBM keeps a "book" of all the orders everyone wants to execute at whatever prices they are waiting to get, either to sell higher or buy lower than wherever IBM is trading. Specialists are "market-makers" whose job is to "maintain a fair and orderly market" by offering to buy and sell stock based on customer orders, or for themselves to make a profit for their own account, and in the process not allow the stock to trade wildly up and down.

Now, because orders get split up across different exchanges and trading venues, no one can see all the "order flow" in one stock anymore, and no one knows how other orders being executed elsewhere will affect prices.

Orders still get sent down to exchanges but are only parked and waiting to be executed if they're stop orders, limit orders, or orders with specific instructions attached. For the most part, buy and sell orders are sent to exchanges and trading venues, executed or cancelled.

Because investors and traders are quick on the trigger to cancel orders, the minute markets start to dive, they cancel their buy orders, not knowing how low stocks could drop in a major sell-off.

The net effect is there aren't many "standing orders" backed up on specialists' or market-makers' books.

That's why sell orders can crash markets. There are no buy orders waiting to catch those sell orders, and stocks and markets free fall.

The handmaiden to multiple electronic trading venues is "decimalization."

For 200 years, stocks in the United States moved in increments of eighths of a dollar. One-eighth of a point was $0.125, and one-fourth point was 25 cents, and so on, and eventually they traded in 1/16ths and 1/32nds of a dollar. But by April 2001, they could trade in one-penny increments.

Decimalization did two things. By narrowing the bid and offer spreads, it killed specialists and market-makers, once the bastion of fair and orderly markets. And penny increments feed high-frequency trading bots.

When stocks were falling, and specialists or market-makers knew they had buy orders waiting to be executed at lower levels, they would use their own money to buy stock, knowing they were taking a risk that more sell orders could come in and take the stock lower. But if they bought stock and arrested its fall, the next "tick" higher would be an eighth of a dollar, or 12.5 cents per share, a profit worth taking the risk for.

But now, with the potential next tick being a penny, specialists and market-makers aren't willing to buy and don't take the kinds of risks they used to. Decimalization killed their incentive to maintain fair and orderly markets.

The high-frequency traders, however, feed on pennies from heaven.

High-Frequency Trust Falls

HFT shops exist in the space created by trading venue competition and decimalization.

What their superfast computers do is read the order flow, the buy and sell orders being sent from everywhere into all the exchanges' servers, where traders expect their orders to be posted or executed.

By "co-locating" their servers right next to exchanges' servers (in 400,000-square-foot server parks built by exchanges to rent space to HFT shops and hedge funds for up to $25,000 a month), their computers can "see" what orders are about to get to exchanges. And, because their computers are faster than everyone else's, they can jump ahead of those orders and execute against those orders for themselves.

They aren't long-term traders. They are looking to immediately trade out of whatever position they get into, for a penny or less. They do that millions of times a day, all day, every day. HFT is highly profitable.

Except when markets go haywire.

When markets are going up, as they have been, HFT shops are proud to tell anyone who will listen that they provide liquidity and help investors execute their orders, because they're there for them.

That's rubbish.

When markets are crashing, high-frequency traders turn their computers off, because there is no more trading in pennies. Stocks are gapping down, sometimes dollars at a time.

Oh, they're still watching. Their computers will see buy orders coming in and get ahead of them, knowing that there may not be many sell orders in the pipes, and their buy orders will start lifting stocks in a vacuum of other orders. That's how stocks bounce back hundreds of points at a time.

It's frightening. The market's mechanics are faulty, to completely understate the issue.

It can be argued that today's mechanics are the unintended consequences of competition, of technology, of the desire to narrow spreads and reduce trading costs. But they are dangerous and frightening.

There are sell triggers like Feb. 2's better-than-expected growth in wages, or more jobs being created, or by rising bond yields, or political triggers - it doesn't matter. They happen.

But selling that drops markets by 1,000 or 2,000 points isn't the result of some trigger or even multiple triggers. The wild drops and the swings are purely the results of the market's mechanics.

Next, I'll tell you what you wish people knew about volatility last week and what effect it really has on wildly swinging markets. I'll also tell you exactly how to manage the new market mechanics to make money on the way up and on the way down.

Until then? Don't trust what you're hearing from people who call these swings "orderly."

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The post What Wall Street Is Desperately Trying to Hide About These Wild Markets appeared first on Wall Street Insights & Indictments.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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