Dr. Algolove

 | May 06, 2013 | 2:27 PM EDT  | Comments
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It's time to learn to stop worrying and embrace the bomb that is high-frequency trading.

Three years ago today, the trading computers, the machines that enter buy and sell orders, broke down, causing the Dow to plummet about 1,000 points in a very short period of time.

I remember it well. I had come out early for my "Stop Trading" segment with my friend Erin Burnett and the Dow had already started to crash, ultimately plunging about 1,000 points in a matter of minutes.

People may not recall at the time, but there were ferocious riots in Greece at that very moment and the televised brutality in that tinderbox was freaking out investors and traders. So the perception, as the slide began, was that somehow this sudden price decline had to be related to actual events.

At the time, I had been studying the phenomenon called high-frequency trading, where rich trading firms tried to get a millisecond edge on each other and larger buyers and sellers in what we used to call illegal front running, but has since been accepted by the SEC as totally legal and even positive buying and selling that gives the markets more depth and liquidity.

After my studying I came to the conclusion that these high-frequency traders actually did the opposite. While they may look like they are all bidding for stock, giving the illusion that markets were deep so to speak, I thought they are all pretty much set to the same frequency, the one that says when there are many sellers step away or you are going to get hurt.

I had discovered, after a lot of investigation with friends who are intimately involved in supporting this kind of trading, that there was a possibility we could have a quick sudden sharp decline because these buyers would vanish as they are really there to run ahead of other larger orders in a perfectly legal way. If larger firms are scared and back away because of big selling related to events, known and unknown, then these quick buyers would not be able to stand there and support the markets themselves. They would disappear. In fact, they might switch to be on the sell side and exacerbate the decline.

That's precisely what happened that day. Buyers vanished. Stocks like Procter & Gamble (PG) fell 30 points in a matter of minutes. Hundreds of billions of dollars were lost.

When I came out, I quickly realized that this was exactly what I most feared. There were no large buyers trying to buy stocks on the cheap and no high-frequency buyers to support the stocks either. Plus, the New York Stock Exchange, which has specialists designed to slow things down to make fair markets, had become a much smaller factor in trying to stabilize things. Most of these trades happened away from the Big Board.

Anyway, I tried to let people capitalize on it by urging them to put in limit orders above where stocks seemed to be trading on the ticker. People who listened made fortunes. People who panicked and sold lost fortunes.

Subsequently the government attempted to figure out what really happened. But it never could. Instead, it put through some trading restrictions involving percentage declines that would end these kinds of flash crashes. Frankly, I don't know if they really work. Which is why I say, get used to it. These crashes could be the norm.

My advice is that as individuals you should be profiting from the machines. Put limit orders underneath your favorite stocks. Maybe you can buy PG down 30 points next time. Corporate treasurers should make sure your buybacks have orders at every price down, so you can profit for your shareholders. Don't be buffaloed. I have handled many a corporate buyback and you can, indeed, take advantage of the chaos to get better prices.

The government has subsequently and repeated endorsed high-frequency trading as a benign method of making money when trading. It doesn't matter if, as Warren Buffett said this weekend, it is producing no value and distorts the meaning of the exchanges. It is here to stay. Learn to stop hating it, embrace it and profit from it.

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