The victims of high-frequency trading

October 12, 2009

Even with all the fuss over high-frequency trading, there has been too little focus on how retail investors can get fleeced by Wall Street’s superfast computer-driven trading programs.

Brian Watson’s story is one that both ordinary investors and regulators should heed.

On April 28, Watson was caught in a freak trading storm as shares of Dendreon plummeted 69 percent in 70 seconds. The Seattle biotech’s stock plunged to $7.50 from $24, as the company got ready to provide investors with an update on its experimental prostate cancer treatment drug.

In little over a minute, the equivalent of an entire day’s worth of trading activity in Dendreon’s shares took place before the Nasdaq stock market halted the stock.

By then the damage was done. The lightening fast selling triggered a so-called stop-loss standing order Watson had with his broker to sell Dendreon shares if the stock fell into the low $20s. But the stock fell so fast that the broker didn’t actually sell Watson’s 1,500 shares until the price had hit $15.

Watson forfeited $18,000 in unrealized gains and absorbed a $1,500 loss. Now that may not sound like a lot. But it’s a bitter pill to swallow when you consider that Dendreon shares quickly rebounded from their pre-crash level after the company reported generally positive test results and trading resumed.

And Watson is not alone. A similar thing happened to Brett Burdick and anecdotally to many other retail investors who had placed stop-loss orders with their brokers on shares of Dendreon.

There has been speculation that short sellers, traders who look to profit from the stock’s plunge, spread a rumor that Dendreon was going to report poor test results for its cancer-fighting drug. Others theorize that a broker incorrectly typed in an outsized sell order, which panicked others in the market.

But no matter what the precipitated the sell-off, it’s likely that high-frequency trading magnified it-given that these automated trading programs control more than half of the daily stock trading in the United States.

Some of the algorithmic programs that drive high-frequency trading desks are designed to spot an unusual trading trend — such as a sudden decline in a stock’s price-and jump on it. Other programs, meanwhile, are written to automatically cancel bids to buy fast-falling stocks in order to minimize losses.

“If an HFT guy steps away from a stock, that can drive it down,” says Joe Saluzzi, a co-founder of Themis Trading in Chatham, NJ and an outspoken critic of superfast computer-trading. “It’s not necessarily the shorts pressing a stock down, it’s also because of bids disappearing.”

It’s all perfectly logical from a trading perspective. But when these two strategies come together, it can create a vacuum-like force that allows a stock to plunge in a short span of time. This is the kind of unintended systemic shock to the markets that has got critics and even some advocates of high-frequency trading nervous.

It is one reason, as my Reuters colleagues Jonathan Spicer and Herbert Lash pointed on Oct. 9, that a small group of high-frequency traders want to create a market-wide monitor to be on guard for malfunctioning computer trading programs.

Yet it’s not clear securities regulators are sufficiently worried about the potential systemic risk posed by high-frequency trading. And that should worry everyone.

When regulators talk about high-frequency trading they often focus on seemingly obscure things like whether traders should be able to put their computers close to the stock exchange to maximize trading speed, or buy and sell shares through less-than-transparent “dark pools”. These are all important issues, to be sure.

Yet they pale when compared with the threat of a high-frequency trading program sparking a sudden and inexplicable sell-off in a stock.

That’s why it’s imperative for regulators to come clean with what, if anything, they know about the events that led to the April 28 debacle in Dendreon shares.

It’s been five months since that event, and investors are entitled to answers.

More commentary on high-frequency trading:

A Goldman trading scandal?

What’s the frequency, SEC?

Wall Street meets The Matrix

11 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

High frequency traders are stealing liquidity by getting in front of the orders of real investors (both institutional and retail). The practice is undermining market confidence. “Flash orders” are only a fraction of the offense. Chuck Schumer needs to write another one of his famous letters.One of the great lies is that “High Frequency Trading adds liquidy to the markets” – it doesn’t. If the practice added liquidity High Frequency Traders would be focused on the illiquid small and micro cap names where inefficiencies are highest and instead they overlook small and microcap stocks and focus on the large cap stocks that are innately liquid.The SEC must force disclosure of all orders from all venues traceable back to both the investor and the venue(s)immediately – even if disclosure is delayed (1 month) to protect the execution of orders. Analysts and the media must be able to see once and for all what really is going on. (I’m not a Constitutional Attorney but the spirit of this should be consistent with the Freedom of Information Act).Recent senior staffers at the SEC have left me with the impression that the SEC doesn’t have the data, analytics or knowledge base to get behind the practice. Congress itself doesn’t have a deep understanding of capital markets – As the author points out, this is indeed an accident waiting for a place to happen.

Posted by Andy | Report as abusive

[…] shadow domination of markets emerges, courtesy of Matt Goldstein’s latest column “The victims of high-frequency trading.” Matt focuses on the blatant example of a self-perpetuating myth, driven exclusively by […]

Posted by Was HFT Responsible For Investors’ Massive Dendreon Losses? | Froogalizer.com | Report as abusive

Who cares what happens on the Wall Street anyways? Let them boil in their own juice and die a slow death. Now this is what I call a crisis.

Posted by Marian | Report as abusive

Oh really, this is supposed to be news?The high speed algorithmic programs operate across all markets: stocks, resources and currency and they are driven by the market makers. If you don’t enjoy the excitement of gambling/speculating then stay away from casinos, horse racing and the financial markets because they are all the same thing and operate in similar fashion.The computers and stop loss hunters that do the work for the market makers can be beaten but it is very difficult to do. Losing money is easy and winning is hard.

Posted by Gregory | Report as abusive

Interesting that the example used in this article was a investor/speculator who got gapped out of a stop-loss order… dont they teach you that in an intro finance course? Market discontinuities can wreak havoc on those with stop-loss orders.Markets need the HFT to lower bid/ask spreads and allow more seamless pricing. As noted above, if HFT account for 50% of the volume. Imagine the difficulties that may be encountered if they were not in the market.

Posted by John | Report as abusive

It is really irresponsible to pin the blame on HF trading for this particular incident without a thorough analysis of the trade history. The author mentioned a few potential causes for the anomalous price movement and proceeded swiftly to conclude inexplicably that it must be due to HF trading. Then in a following paragraph, he suggested that if the HF machines pulled the bids without an active aggressive sell order, the stock would have plummeted anyway. This is quite telling; (1) This acknowledges that HF trading provided a comparatively tight market by being active in the market, and (2) If you subtract HF activity from the market, it would have revealed a far larger spread and just as violent moves in markets. For retail investors trading in smaller sizes, the HF trading firms provides a great service in almost all cases in terms of immediate liquidity at a tight spread. Do you know what the markets looked like before the advent of HF trading firms to the ordinary retail investor?I understand that it is difficult for journalists to penetrate trading secrets of HF trading and it must seem threatening to have algorithms trading. But projecting fears, extrapolating algorithm behaviour and hypothesizing market reaction is bad journalism. Please find a reputable HF trading firm, sign an NDA and find out more. You’ll likely be surprised how many ‘species’ of HF trading there are.In my experience, sudden anomalous size and aggressive price of trades over a sustained period are more likely to cause the kind of large fluctuations in stock prices illustrated above. It is also my understanding that a lot of the the liquidity providing algorithm of the HF trading firms generating a significant proportion of normal trading volumes would have stepped away during periods of extreme volatility.To make things more folksy: No one in his/her right mind would walk into an ecosystem and decree that entire species are bad and should be eliminated without careful study. Even then, we have learnt that we always run the risk of unintended consequences. Let me try to define some subspecies of HF trading:a. There are the herbivore grazing species that like fairly orderly markets and provide liquidity with tight spreads in order to earn rebates from exchanges. They compete with each other to provide better prices so as to be able to trade. I am fairly confident that this class of market participants generate the lion share of the HF trading volume. These are fairly dumb creatures who care only to collect rebates.b. There are the small predatory species that act like small retail investors on steroids. They typically do not collect rebate and act to take advantage of price inefficiencies with small bet sizes. They are important to the ecosystem as they provide liquidity to species (a) like other investors. Without (b), (a) would probably starve to death.c. Finally, there are the big scary dinosaurs with huge appetite for risk. They are characterized by very big orders and aggressive prices. Unlike species (b), they are not interested in microscopic profits. They jump in when they judge that price dislocations are large enough to justify their risk and trading costs. They are only thought of as subspecies of HF trading only because they are utilizing algorithms to take liquidity aggressively over a short time interval. Without (c) to provide macro or long term price correction, (b) will have not much information to trade on and (a) will starve.When all (a..c) die, you’ll find that retail investors would have to deal with human specialists and market makers with much wider spreads and lower liquidity and they have the same incentives to probe your stop orders. You’ll pay more to your brokers and competition drops off. I have not even started describing how this drop off in liquidity would affect derivatives pricing and trading and this snowballs into ETF market making and annuities costs.I hope the above helps. BTW, I do not work at a HF stock trading firm.

Posted by TW | Report as abusive

The stop loss guy can help protect against HF blips by setting his stop losses to work on a moving average price not the instantaneous market price. This will smooth out short-term HF blips but will delay exit if it’s a real trend against the position. It maybe good to have the length of the MA cover at least overnight as most HF/ algo trading firms need to be square before close of day so prices tend to settle again.It’s no good crying though as your stop loss proves that you too are trying to take the upside but without the downside risk which is just what HF/ algo traders also do …

Posted by Paul J. Weighell | Report as abusive

[…] Matthew Goldstein at Reuters tries to cite trading in the biotech company Dendreon (DNDN) to highlight the dangers […]

Posted by High-Frequency Trading Is Not Why You Got Screwed On That Trade | Bailout and Financial Crisis News | Report as abusive

Gold, as a solid tangible metal I can grab with my hands, seems more and more alluring. Not only it’s pretty to look at, it also has practical industrial applications. Melt it and it’s back to new again.So, the more volatile the computer systems make the stockmarkets, the more interesting something solid becomes. What are numbers? Abstract representations of things.When there are no things to represent, merely numbers for numbers sake, backed up by less than nothing, ghosts that will never leave the loop of a computer system, they can’t be reliable enough to bet your money on them.High frequency trading is like the guy on the corner of the street with three cups and a pea. He will use his skills in manovering the objects and hussle you into giving him your money by arousing your ego and curiosity.It means high frequency trading is a place for only two type of people: husslers and berries.

Posted by Dan | Report as abusive

It’s very simple just don’t use stop-loss orders. No body is obliged to sell or buy at a particular moment. Traders should look at the fundamentals and the medium to long term moves not the daily suspicious moves.

Posted by Ramon Ayala | Report as abusive

“It is one reason, as my Reuters colleagues Jonathan Spicer and Herbert Lash pointed on Oct. 9, that a small group of high-frequency traders want to create a market-wide monitor to be on guard for malfunctioning computer trading programs”Yeh, right. Institutionalize high speed trading but requiring the GOVERNMENT to pull the switch when the BUSINESS owned programs screw up.Much better to either:(1) Hold the owners LIABLE when their programs screw up;or (2) Only allow the programs to enter or cancel bids at fixed and known times (ie our bid starting at this second is)or (3) Ban high speed trading

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Matt — Disclosure: I do PR for NYSE Euronext, which runs the New York Stock Exchange and other markets.One aspect not discussed above: had Dendreon been listed on the NYSE, I don’t think there’s any way the stock would have lost almost $17 in 70 seconds. Had it been on NYSE, a designated market maker would have spotted the move and worked with exchange staff to immediately halt the stock until the situation could be sorted out. The rapid price change also would have triggered Liquidity Replenishment Points, which pause automated trading briefly and also would have called attention to it.We have seen this movie before, for example, last year with the stock of UAL Corp., as I blogged about here:http://exchanges.nyse.com/archives/ 2008/09/ual.phpI am not kicking fully automated markets — we operate several ourselves — but I am suggesting that having people with assigned responsibilities to make fair and orderly markets in specific issues, and take action before such mistakes get to be much of a problem, is a benefit of the NYSE market model that is often overlooked. — Ray

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Posted by Dendreon’s Stock Plunge, High-Frequency Trading, and the Difference That Listing on NYSE Could Have Made » Hybrid News | Report as abusive

I can understand the social value behind arbitrageurs, behind _professional_ money managers and long-term investors. But the only function of naive uninformed noice traders, be they retail, institutional, using HFT or not is to feed those groups.This is a story of naive trader which, instead of indexing, doing long-term investing or outsourcing money management to someone else, tried to _gamble_ on the market and failed. I state that he wasn’t an _investor_. He expressed a view on the market behavior and it has happened to be wrong. What is the problem with that? If the problem is actually stock volatility, then depending on market structure liquidity providers should be encourage to add liquidity in this case and value traders to take speculative positions in it. But maybe these stock were not interesting enough for them, comparing to either someone “predatory” trading or just impatient liquidity demand.BTW: people were telling such stories ten years ago without any HFT stuff at all.

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