The Consequences of Frequent Trading

On a recent flight from Zurich to Nairobi, I met with Mike Jones, Managing Director of Argent Advisors Inc. based in Ruston, Louisiana.

As I studied financial economics at the SSE and used to work with investments, I keep a keen interest in the subject. Therefore I enjoyed to talk with Mike about investment strategies and the current state of the financial world, and in particular about how speculation and high volatility damages the markets.

Mike told me that from 1927 to 1999, the average holding period of NYSE stocks was just below four years. Then from 2000 to 2011, the average holding period was reduced to three months.

This means that all the stocks available on the New York Stock Exchange are held by an investor on average three months!

Like most stock markets, all trading on the NYSE used to be floor based auction market. As of January 2007, all NYSE stocks can be traded via its electronic market. Customers can send orders for immediate electronic execution, or route orders to the floor for trade in the auction market. As orders are sent, they can be flagged with certain conditions to be fulfilled, for example duration.

charging bullI have verified the above statistics of three months and it is the current state of the NYSE market turnover speed. In fact, looking at the type of trading going on, the situation is even worse.

High-frequency trading now accounts for almost 75 percent of all buying and selling of U.S. equities. The high frequency traders are manipulating the market in order to make money on the market makers.

The bid-ask spread on stock markets is largely set by traders who act as market makers. They do not speculate on price movements, but stand ready to take either side of a trade, and aim to profit from the spread.

sleeping bullMarket makers can reduce spreads to attract trading, but they can not go too far because they face risks, for example, that a stock they buy might lose value before they can sell it. Ultimately, the bid-ask spread reflects how much market makers have to charge to take on such risks and still be profitable, while making it easier for everyone else to trade when they want.

High frequency traders profit from this, by speculating on markets makers behavior.

So, can one really any more talk about the stock market as an investment market? The market has become increasingly hard for someone who wants to be an investor.

orc softwareIntra-day trading has become increasingly common with people who do not want to keep overnight risk, and with the development of efficient automated trading software like ORC Liquidator, high-frequency trading is more and more common, in which stocks are sometimes held for less than a few seconds.

Those of us who went to business school were taught that high volumes on the markets smoothen things out and allows for gradual price change toward the true value.

In a world of high-frequency trading, this is not true. In times of market adjustments, firms that use computers to buy and sell thousands of times per second, helps trouble spread, instead of calming price movements down.

Given the statistics, can we please stop pretending that what most investment managers are doing every day is “investing”?

Holding stocks for on average three months is not investing.  It is trading.  And because trading is a negative-sum game, one largely focused on trying to figure out what everyone else is doing, it is really speculating.

When you are speculating, there is no reason to pay attention to things like value investing, fundamental analysis, future cash flows, and all the other facts about companies that relate to the real world.

For holding periods of less than three months, fundamental data is pointless.  Over holding periods that short, the game is all about figuring out what everyone else thinks and then gamble that you will be right and they will be wrong.

So, dear world, how and when can we get back to sanity in the stock markets?

speculationThere is actually quite a lot that can be done by the market supervisors.

Many politicians today favour a transaction tax, like the Tobin tax on currency trading. I do not believe in this. Taxes on financial transactions would be abused and it would harm the efficiency of working markets.

Instead, the regulatory authority could require all orders to be marked as non-conditional to stay alive in the marketplace for at least several seconds, so they can not be immediately cancelled. Some stock exchanges already specify this, but it should become a regulatory requirement.

Second, if a high frequency trader wants the freedom to cancel faster, he should be required to clearly mark his order as conditional – and show his ratio of orders to actual trades. This would allow other traders to quickly notice who in the market are running speculative schemes and avoid them.

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