Are the Markets Being Manipulated?

What if I told you I have a secret trading system that’s right 98% of the time?

Would you be interested in what I thought the market was going to do next?

Or would you just think about how even the best traders and investors are right about 2/3rds of the time. And that kind of consistency, combined with proper discipline, is enough to make a fortune over time.

You could just call me a liar, a criminal, or a crook too.

Or you could just assume I work at Goldman Sachs (GS).

That’s right, with earnings season just around the corner and another round of seven and eight figure bonuses for the top traders at everyone’s most hated investment bank, the headlines will focus on the size of the bonuses instead of how they were made.

But if you go beyond the headline-making bonuses, you can see how they made so much money and how you can use it to your advantage.

Minting Money

Over the last year Goldman has become a probability-defying trading machine.

The firm’s success in the second and third quarter of last year was unbelievable. There were 65 total trading days between April and June. As the rally was still in the early stages, Goldman’s trading department lost money on just two of those days. That’s a success rate of 97%. And it made more than $50 million on 89% of the days.

Tough to do better than that, huh?

Well, Goldman did just that in the third quarter. The firm had only one losing day and booked profits on 98% of the trading days. They made more than $50 million 84% of the days.

At this point, I see no reason why the fourth quarter will be even better when the final numbers are released in a few weeks.

The masses, however, will focus on the bonuses paid to Goldman’s traders and executives and miss how they did it and the risks and opportunities created by it.

Too Good to be True Honest

Last year Main Street learned a lot about a Wall Street’s secretive High Frequency Trading (HFT) and the mountains of profits made by it.

As we discussed before, HFT combines how-powered computers that are plugged directly into stock exchanges and run according to the algorithms created by mathematicians.

HFT systems trade for pennies and buy and sell millions of shares a day. According to Thomson Financial, HFT now accounts for 60% of all daily trading on the major exchanges.

The Rewards…

HFT is growing in popularity and took center stage last year largely because it’s so profitable.

To say it’s lucrative is understatement though. The New York Times called HFT “a way for a handful of traders to master the stock market.” And it has clearly played a big role in the allowing the kind of success rates Goldman booked last year.

The rewards of HFT are generally concentrated in the hands of the few. The HFT traders who build the systems reap most of the rewards.

Individual investors, however, also benefit. For example, if you have a sizeable trading account, it’s not hard to build or eliminate a position worth hundreds of thousands of dollars without pushing a stock’s price around too much. Getting in and out is easy because the HFTs help make a lot of volume than would otherwise be there.

And the Risks

The risks involved with HFT are what most investors should be concerned about.

As we head into the New Year, the sell-offs of 2008 and early 2009 seem like a very long time ago. They haven’t been forgotten yet, but they’re fading memories for many investors. There will come a time when most everyone is overly confident again.

That’s where HFT comes in. The HFT systems are programmed to take advantage of trends and other market anomalies. They are machines that trade in milliseconds and essentially run on their own.

At any moment the HFT trading systems could catch a downtrend. Wall Street Journal over the summer noted, “A rogue firm’s system could destabilize parts of the market, even leading to a broad-based market selloff, without proper oversight and risk controls.”

That’s the real risk. When a lot of the computers start catching the same signal, it could spark a major sell-off. It’s happened before.

Does anyone remember the 1987 stock market crash?

The economy was strong, company fundamentals were improving, and the market was setting new highs. Then, all of a sudden, it stopped one day and the Dow fell 22% in a single day and lost more than 30% of its value when all was said and done.

The catalyst for the crash was automated trading systems and complex portfolio insurance schemes. Together they were the early versions of HFT systems. They’ve come a long way since then.

That’s why at some point in the next five to 10 years, another out-of-the-blue crash will likely happen again. Sure, there are limits on how much the major indices can move, but rules and regulations don’t always prevent the next problem, they usually only add to it.

Taking Cover and Finding Opportunity

All in all, HFT is kind of kind of hard to talk about. It’s not very tangible. Most financial analysts have been trained to look at fundamentals and else (how many professional market technicians are there or who really focuses on tough-to-quantify market psychology?). It’s also highly secretive and only a handful of folks actually know how it all works.

However, we do know HFT has grown to the point where it dominates daily trading volume. And when that happens, there are bound to be unintended consequences.

After all, the HFT systems have helped a lot of “weird” things to happen in the markets.

Most market action now occurs in the first half hour of trading (when HFT systems are building positions) and the last five minutes (when HFT system are closing out positions for the day).

You’ve got a single firm, Goldman Sachs, having unbelievable success rates.

We’ve also watched countless “mini trends” driving the market for weeks at a time. Since the market fell apart in 2008, countless sectors have fallen into and out of favor every three months or so. We’ve covered most of them here. Remember looking at why the “too crowded” trades in infrastructure stocks and the run-up for for-profit education providers didn’t make any sense? They were some of the mini-trends which just go for no real fundamental reason. A good back-story was created after the runs.

But for long-term investors, there are steps we can take to protect ourselves and be in position to capitalize if (when) a computer-driven, irrational sell-off happens.

For starters, not being 100% invested, maintaining a minimum cash balance, and using trailing stops (which automatically prevent you from riding a stock all the way down) are all protective measures to ensure you are in place for when it does happen.

So whether it’s a conspiracy, Wall Street taking over the market, or anything like that, we know HFT is a growing trend, some folks are making fortunes, and there will be a price to pay someday.

Until then, it looks like 2010 will be just like 2009 – extremely profitable for those of us who don’t’ try and beat the computers/Wall Street and simply take what the market gives us.

By Andrew Mickey

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