As legendary boxer Muhammad Ali once noted, “Your hands can’t hit what your eyes can’t see.”
Investors watching the fallout from the Knight Capital Group trading fiasco now worry about computer trading, but they should be more concerned with dynamics happening virtually unnoticed or out of sight.
Worse yet, many investors are fighting back against what they see, thinking they can protect themselves, when they might simply be making themselves more open to a stock-market sucker punch.
The reason why is something Ali understood.
Regulators and the market itself strike back any time they see and recognize what is happening. Likewise, investors react to the events they see and, therefore, believe could happen again.
They can’t punish actions they don’t see. Likewise, they can’t stop what they don’t see coming. Read more: Forget Knight; there’s no investor confidence.
Consider the Knight situation versus a trading event days earlier that the market ignored completely.
On Aug. 1, a malfunction in Knight Capital’s trading system flooded the market with erroneous trades, action reminiscent of the “Flash Crash” of 2010. The troubles resulted in some $440 million in trading losses – now estimated at roughly $275 million after taxes – which left the firm scrambling for a financial rescue.
While that bailout came, there was a steep cost beyond just the trading losses, namely control of the firm. Knight’s new investors control nearly three-quarters of the company, and they got it for a song; existing shareholders have seen their stakes significantly diluted, and the company faces the daunting task of retaining clients.
As in seemingly every trading scandal popping up these days, most Main Street investors had never heard of the firm before the blow-up; Knight is a trading firm that takes orders from big brokers like E-Trade and TD Ameritrade, routing them to the exchanges where the stocks are traded. One key role Knight Capital has played is that of “designated market maker,” where it is responsible for maintaining orderly trades in the stocks it oversees.
Designated market makers are particularly important whenever there is a lot of market volatility; Knight is responsible for the trading of 524 NYSE-listed stocks, a sizable chunk of the roughly 2,300 total corporate issuers.
Until its blunder, Knight was a respected top-level player, a distinction that makes its slip more alarming, because the worry is that if this could happen at Knight, it can happen anywhere.
That is why regulators and market experts are going to look at this case and try to figure out how to improve conditions and avoid the problems.
But now let’s consider something that happened on the market on July 25.
I was tipped to this information by a money manager who could not recall the investment newsletter or blog he had seen it in; I wish I could give proper credit, but I have verified the numbers.
On July 25, 11 minutes before the release of the crude oil inventory report, there was some kind of trading event in the stock of BP Plc., one of the world’s leading oil and gas companies.
Over the span of just 2.25 seconds, BP stock gained almost 3 percent in value; it held that level for half a second, then dropped about 2 percent in the next 2.25 seconds. Some 600,000 shares traded during the uptick, and about one-third of that moved during the fall-back, but it was about 15 percent of the day’s trading volume (and it’s worth noting, this was not a heavy-volume day for the stock).
Over the last two years, BP’s trading range for an entire day averaged 1.8 percent. More than 90 percent of those trading days, the spread between the high and low was less than the move BP experienced in those first 2.25 seconds.
Think about that for a moment: The stock’s average range for a full trading day – that’s 23,400 seconds – was less than what it posted in just five seconds.
Traders I talked to had no explanation. They called it a “blip” or a “flutter” and basically said it was meaningless.
They also said stuff like this “happens all the time.”
That’s not comforting, because most people would say the situation was high-frequency trading formulas run amok.
The powers-that-be know they have big problems here; they need a new generation of “circuit- breakers” and protections. They know that while the current market infrastructure suggests that there is real money and liquidity backstopping this kind of action, the truth is that it’s a trading market where insiders and sharpies are trying to scalp the spread, confident they can make a fortune without ever having a reckoning like the one Knight Capital had.
For the Main Street investor, the problem is that these kinds of events create what some observers call “air pockets,” places where a stock suddenly bounces sharply and leaves investors feeling like they are in free fall.
On a day-to-day basis, this may mean nothing. If you looked at BP at the start and end of that wild trading day, you noticed nothing.
But if you had some sort of risk-mitigation strategy in place – a stop order or something set to sell or buy at a certain price – you wound up trapped in the pocket.
“The irony is that people see this volatility and the trouble in the market and they want to protect themselves from it, they want to manage the risk,” said Kurt Schact, managing director of the Standards and Financial Markets Integrity Group at the CFA Institute.
“The retail investor who is trying to mitigate some risk is using tools to protect themselves that were developed in a different generation,” he added. “Their protection is being triggered by these unusual electronic, high-frequency trading events – we get a lot of complaints on them – and instead of reducing their risk, they wound up making it worse.”
In short, they got sucker-punched. In trying to avoid the problems they could foresee, they wound up being hit by something they never saw coming.
It’s tough for the Main Street investor to feel they can win in that kind of environment; it requires diversification – for protection – and some faith that short-term scalpers won’t interrupt the long-term trends.
It’s hard to have that faith. While regulators and politicians try to solve these problems, as long as they work only on what they can see, the next trading scandals are not likely to be stopped.Chuck Jaffe is senior columnist for MarketWatch. He can be reached at email@example.com or at Box 70, Cohasset, MA 02025-0070.