High Speed Trading and the Small Investor

The advent of electronic trading in the 1990's brought a faster dimension to the trading experience when it began to replace the system whereby traders on the floor of exchanges would buy and sell by shouting orders at one another. As improvements in technology accelerated the speed of communications and made transaction processing ever more efficient, so more traders opted to go this route, and today it is the rule rather than the exception.

By the late 90's electronic trading had also become available to the little guy - the retail investor. In America 20% of the population took advantage, compared to 5% ten years earlier. The man on the street could participate easily, and also relatively cheaply.

But retail investors have a minimal impact on market movements, because the vast volume of traffic goes through institutional investors, banks, hedge funds, private trading firms and exchanges, all trading with one another. And they've always had the advantage over the little guy, just by getting their orders filled faster, and by being closer to the action. The use of electronic trading sped up the process from day one for everybody, so where does high speed trading fit into the mix today, and why has it become suddenly so controversial?

High speed (also known as high frequency) trading utilises fast processors and fibre-optic communications lines to place multiple orders that are transacted incredibly quickly (in milliseconds) to get in and out of the market at a rapid rate. They take advantage of even small price differentials to make small profits, but by placing millions of transactions these profits add up to significant amounts. The principle behind it all is one of gaining advantage by being able to exploit these differentials ahead of everyone else. The programs driving the trades consist of complex algorithms that look for specific market conditions, which once found trigger a buy or sell order, or sometimes a cancellation if this suits the purpose. Current estimates put the volume of all current exchange trading by high speed traders at around 50%. And it's so profitable that a firm called Hibernia Networks is allegedly spending $300 million to run a fibre-optic cable across the Atlantic to connect Wall Street and the City, just that few milliseconds faster.

High speed traders say they bring benefit to the markets by acting as market makers who provide enhanced liquidity, and by narrowing the bid to offer spreads, thereby making market participation cheaper. They also claim that it makes the market more efficient. Critics respond by citing the opportunities high speed trading creates for manipulating the market. An example of this often quoted is the practice of 'front running', where a trader anticipates your order to buy a block of shares, and before you can place your order he has bought in ahead of you, driving the price up. He then  sells them back to you for a profit. Essentially he's using his advantage in speed and volumes of transactions to drive a stock down, then buy it back for later sale at a higher price.

This kind of behaviour generates an ethical argument. By getting in first the high speed trader could be said to be acting on inside information, which is not only unethical but also illegal. In fact, in April the FBI announced that it was opening an investigation to establish whether high speed trading firms are practising insider trading. The results should be interesting, to say the least.

Another alleged practice is the detection of stop losses in the market. The high speed trader once again takes advantage by selling to trigger the stops, then profits when the price swings up again. So if you're a small investor with your stop in the same place as thousands of other players, some of whom are trading large volumes, your relatively trivial trade could be taken out at the same time.

The complex and sometimes less than well tested algorithms have caused market volatility way in excess of the norm. The so called 'Flash Crash' of 2010, when the Dow Jones Industrial Average dropped 700 points in minutes, was triggered by an algorithm executing a sell trade based on volume and not price or time. Other high speed trading firms leapt in to buy, but then tried to reduce their positions minutes later by selling. The original algorithm then increased the volume of sell orders, and the market went into a tailspin. At some point the original instigator must have pulled the trade, and the market recovered by day's end. This kind of computer generated volatility has caused controversy, and dents investor confidence.

So how does all of this affect the small investor? You could argue that high speed trading damages our pension funds by anticipating and profiting from the trades these funds make on our behalf. Or that our insurance premiums are affected when Insurance companies suffer in the same way. Perhaps the unexpected volatility caused by the odd flash crash adds an increased level of risk to your trade, should you be unlucky enough to be in the market on the day. Or maybe you'll suffer when your stop loss triggers as a result of a market algorithm.

But the truth is, high speed traders aren't interested in the little guy. They spend most of their time competing against each other, and if they were to target retail trades the volumes involved would most likely be too insignificant to be of interest. This doesn't mean that the retail investor is immune to the high speed trading phenomenon. An algorithm is logical and takes action unemotionally, which theoretically confers advantage over the human being, who trades subject to fear and greed. I personally don't think this should drive you out of the market, and especially not if you're holding stock for the longer term.

If you want to know more about the high speed trading market and the issues around it, you might like to read Michael Lewis's book - 'Flash Boys', available on Amazon. Only recently released, it seems to have generated plenty of controversy over the practice.

Darren Winters

Trading Forex Fundamentally or Technically, The Battle goes On

The Fundamental vs. the Technical Trader in Forex

In this article I'll take a look at trading forex from two distinct perspectives, i.e. that of the trader who favours the fundamental approach, and that of the trader who prefers the technical method.

Trading on the fundamentals

There's no doubt in my mind that fundamental data can move currencies, but what are fundamentals? In forex they consist primarily of news events and economic data.  A good current example of a news event affecting currencies is the Ukraine crisis. As the tension in the area ratcheted up a few days ago the US dollar strengthened against the Rouble. Should tension ease in the near future, we might expect to see a reversal. To a certain extent news and economic indicators tend to overlap. A change in interest rates is both economically significant and newsworthy.

So apart from keeping up with the news generally and assessing its impact, the fundamentalist also keeps an eye on the economic changes affecting the currency pairs he or she is trading. The easiest way to do this is to consult an economic calendar. These are readily available online, and give the trader a list of events that could impact currencies day by day. Examples include a change in the consumer price index, gross domestic product figures, a speech by the Chair of the Federal Reserve, or the big one in the US - nonfarm payrolls. This measure of all people on the payrolls of non-agricultural businesses can have a major impact on all US dollar paired currencies. It comes out on the first Friday of the month (so this Friday, May 2nd).

A fundamental trader would check the calendar, and depending on his or her expectation against a particular event or events, set up a trade. A surprise result of that particular event could spark a market reaction that kicks the currency either up or down. This could signal the beginning of a trend, but regardless of that it is an opportunity for profit. This is a relatively short term example though. For the longer term a fundamentalist might consult newspapers and financial magazines like the Economist, to form an opinion about a longer term position. Longer term fundamentals that might affect a trader's bias include the Bank of Japan's declared intention to weaken the Yen, and the Swiss Central Bank's pegging of the franc to the Euro (not allowing the franc to exceed SFr1.20 to 1 euro). If you're taking a position and intend to be there for months, then the day to day fluctuations are of less importance to you (this is not an excuse to ignore them completely of course).

So in nutshell, if you're a fundamental trader you're making your decisions based on news and economic data, either as it unfolds or is predicted to unfold.

Technical Trading

A technical trader studies price movement on a chart. As far as he / she is concerned the fundamentals are already incorporated in the price they're looking at, based on the premise that by the time you've heard the news the market has already reacted.

The charts consist of bars showing price variation in a given period. The bars form patterns, which can be interpreted in a number of ways. A stream of bars in an upward direction can be interpreted as a trend. If you're a trend trader this could be a signal to go long (buy), or if the bars are going the other way, go short (sell). The configuration of a chart varies by timeframe. You might have a clear uptrend on a daily chart, but when you go down to an hourly version the price action may be going sideways or downwards. The daily (or higher) chart is your focus to determine the bigger picture of price movement, but if you're trading on an intra-day basis you'll be most likely using lower timeframes like 5, 15, or 60 minute charts to determine where you enter the market.

The bars and their movements over time are complemented by a seemingly endless supply of technical indicators to assist your decision making. The MACD indicator, for example, shows the direction in price based on an algorithm performed on moving averages and their convergence or divergence with price movement. The trader can use this to determine when a change in direction (divergence) might occur, or to confirm the current direction (convergence). This represents one of many indicators that you might choose to use as part of your trading system.

Most technical traders have a set of rules that determine whether they enter a trade or reject a potential trade setup. You might be a trend trader, or a band trader, or you could trade breakouts of lines of support and resistance. There is even an argument for entering the market randomly. The particular style of trading is chosen because you believe it gives you an edge, i.e. a high probability of being successful. Your rules should include knowing how much you're going to risk, and when you're going to get out of a trade, either because you hit a pre-determined level of profit, or because you lost a pre-determined amount of capital risked. Once you have all that figured out all you need to do when the opportunity arises is to execute your trade flawlessly (meaning you don't break your rules!)

To the technical trader the charts represent a simpler and more successful way to trade the markets. The charts are a purer view of market reaction to all the data available at a point in time, and hence a more accurate reflection of what's really going on.

Fundamental or Technical?

Traders have been successful using both methods. Some of this could be attributed to personality - certain people prefer a longer term approach and are comfortable using a bigger picture fundamental method of decision making. Others thrive in the excitement of a fast moving daily market, using charts to place several trades in the course of a day, or are just convinced that the charts are more accurate determiners of where the market is going next, regardless of how often they place trades.

And then there is the argument for combining elements of each: - fundamental analysis to get a feel of longer term direction. combined with technical analysis to determine the best time to take advantage of that direction. You pays your money, you takes your choice.

 Darren Winters

The Tech Boom Then & Now

The Tech Boom Then & Now

Who famously said that, “profits are for wimps!”  You could easily be mistaken for believing that this must have been uttered by some avid socialist. Wrong!  A clue; cast your minds back to the early millennium tech boom. Indeed, this was the prevailing view and said many times by the then budding new economy entrepreneurs.  The owners of these new businesses argued that in this modern world of technological development the traditional methods of evaluating businesses were completely outdated and that profits were for wimps.

But shouldn’t the object of a business remain the same, namely to make a profit, irrespective of whether the entity was a builder of railroads in the 18th century or a provider of technology in the new millennium.

 Back then, the boys with MBA's and shiny shoes from the Ivy League business schools somehow bamboozled investors with impressive business plans. They put forward compelling arguments about forsaking company profits in the foreseeable future for instead the greater good of focusing their goal on increasing market share.                                                 

It was a rather devious plot, if investors seemed weary about the viability of the business, they would be patted on the back and told not to worry; after all who cares about foreseeable profits in short term, when the goal of the business is world domination. Be patient; forsake rewards in the near future for huge rewards in the long term.  The business strategy seemed credible, moreover it tapped into one of the most powerful human emotions of all; greed. Investors scrambled over themselves in desperation to buy anything that had an internet sounding name. Many of them didn’t even understand the business activities, let alone conduct some preliminary research into the financial credibility of the company’s share they were buying. 

But who cares, just buy and hold, then sell next month and bank the profits. It seemed like a no brainer with everyone jumping on the bandwagon.

As the saying goes the rest is history.  The technology bubble ended like so many previous bubbles before it; with a burst, a sharp correction in technology share prices followed by a recession.  Like in all investments, it’s all about timing, knowing when to buy and when to sell. Only a lucky few people were fortunate enough to get out at the right time. The result being that a few people made a lot of money, but even more people lost even more money.

Fortunately, there were a few voices of reason during the internet mania, as it was dubbed back then. The author of “Irrational Exuberance”; Robert Shiller, an economist at Yale University argued in early 2000 that there were many similarities with the technology bubble back then and with Britain’s railway mania in the 1840’s. Would be railway millionaires raised large amounts of capital on the stock market to finance railway construction. Most railway companies never made a profit due to the fact that over investment resulted in overcapacity, which resulted in many going belly up.

So, now in 2014 is the technology sector in a period of “irrational exuberance?”  I would argue definitely!  Moreover, the correction coming is going to be bigger this time around. Regretfully, investors have not learned from the previous correction.  Put simply the objectives of a business is to make profits. Getting back to fundamentals is desperately needed and the traditional methods of evaluating a business are more so valid today in the technological sector.

Let’s revisit some old fashioned ways of evaluating the viability of the tech sector.  For example, the Price-Earnings ratio (PE) is a useful tool in the investor’s box for assessing whether the current market price for a stock is trading at a fair value.

The PE ratio is relatively a simply ratio to calculate; divide the current market price of the share divided by its annual earnings (EPS).  As a rule of thumb, when the PE ratio is high it would indicate that investors are optimistic about the future earnings of a company compared with a lower PE ratio.

Face book’s current PE ratio is 71, which means that the stock is trading at 71 times its earnings per share. To give you some perspectives, the average Dow Jones industrial company trades at only 13 times EPS. Investors normally feel comfortable with a PE of 20.  So Facebook’s PE ratio is sending up a big red flag. Investors are overoptimistic about the future earning potential of the company; the current share price is overvalued.

Let’s examine another useful figure, market capitalization.  This is the total market value in monetary terms of all of a company’s outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. Face Book’s has a current market capitalization 142.99 billion USD.  Again putting this into perspective the British engineering aerospace company Rolls Royce has a current market cap of 32.26 USD billion. The US automobile company, Ford has a current market capitalization of 63.62 billion USD.   

Now ask yourself this question, is Facebook really worth more than four times Rolls Royce and more than twice Ford.  

Facebook may have a billion users, but this glorified bulletin board is finding it challenging to turn users into a revenue stream. Indeed, some users are turning away from Facebook in the belief that their privacy is being violated.  Also the preposterous amount of money that Facebook paid for Whatsapp, the mobile messaging service, 19 billion USD, defies business logic. How many users have switched to rival free messaging services when Whatsapp  tried to charge its customers, who now have free alternatives, such as Line and Tango, just to name a few?

What we are seeing is more than irrational exuberance this time, indeed it seems more like investor insanity!  Perhaps it is fitting that Mr. Zuckerberg now has a wax model in Madame Tussauds  because  when his investors eventually hold a candle to re-examine his business model they may find their wealth vanishing,  just like the melted wax of  Mr. Zuckerbeg’s  model in Madame Tussauds. 

Darren Winters 

Sell in May and go Away - this year?, I fancy a vacation!

What do you think?........

It is a saying familiar to many investors, and it's based on an historical tendency of stockmarket under-performance during the six month period starting in May and ending in October. The advice to investors is to get out of equities over the Summer period, and re-invest in October, ready for a Winter upswing. The logic underpinning this advice is that holding your portfolio in cash or bonds through the Summer period will provide a better rate of return.

The saying originated in the City of London, and when quoted in full goes: 'Sell in May and go away; come back on St. Leger's Day'.  St. Legers is a reference to the St. Leger Stakes, one of Britain's oldest horse races, established in 1776. It normally takes place on the second Saturday in September. I don't know when the saying originated, but a professor of finance in New Zealand claims to have found an article in the 1935 Financial Times that mentions 'Sell in May' as a long established strategy.

But is there any truth to it? The effect was first noticed in America, but has also been applied to the UK and Europe. In 2012 Ned Davis Research produced data showing that had you invested $1000 in the S&P 500 between 1950 and 2012, using sell in May and buy back in October, your investment would have grown to $75,539. On the flip side, had you bought in May and sold in October over that period you'd have amassed a measly $1032. On the face of it, pretty impressive numbers. Comparable research from the Stock Trader's Almanac since 1950 shows the Dow Jones Industrial Average returning 0.3% from May through October as opposed to 7.5% from November through April.

Of course there are years that buck this trend. In 2009 for example, the FTSE 100 gained 20% between April 30 and October 30. In 2012 the FTSE All Share Index finished almost 3% up between May and October, which represented a small gain for those investors who chose to stay in the market. And in 2013 The Dow gained 4.8% over the Summer period. Based on those figures, 'Sell in May' can hardly be taken as gospel. Gospel or not, it remains a staple concept of stock market investment.

So what causes this seasonal shift? It could be down to the natural business and economic cycles of the year. Over the December period for example, technology stocks may tend to rise on the back of new products released for the Christmas market. In the New Year companies can place large orders that boost their recipients' sales results, and which subsequently  feed through to higher share prices. Perhaps the Winter time could be said to be a period of increased consumer consumption, which in turn encourages investor confidence. In the Summer, however, investors can close their positions when they go on holiday. According to the Stock Trader's Almanac, June, August and September are the historical low points for the Dow Jones. The increased investor activity levels of the Winter are simply not reflected in the Summer, and the market simmers accordingly.

The 'Sell in May' phenomenon has been around a long time, and has been used as an allegedly successful strategy by many long term investors. But before committing to it there are some caveats to think about. The transaction costs of getting in and out of the market need to be considered, along with the possible capital gains tax that could be incurred. For those holding dividend paying shares there is a case for staying invested and using the principle of compounding to re-invest those dividends. Then there is the simple alternative of just buying and holding. According to a study by Motley Fool, based on the S&P 500 Annualized Return between 1926 and 2012, buying and holding produces a 10% return. This is in contrast to 8.4% when selling in May and buying back in October, and 5.1% for buying in May, then selling in October.

There's also the issue of how much return your cash can generate while you're out of the market. When interest rates are high then it becomes an attractive option, but given current rates, not one you might wish to exercise right now!

So what about 2014? As we enter May the markets are experiencing uncertainty over the continuing and unpredictable situation in Ukraine. If sanctions imposed on Russia start to hurt, we may see a response from the Kremlin that adversely affects those in the West who currently do business with Russia. Another downside factor in possible market performance is the incidence of mid-term election year in the U.S. Historically stocks have weakened from May through October in a mid-term election year, (as opposed to presidential election years, where they strengthen), and the expectation from pundits in the States is that 2014 will be no exception.

On the up side, there is optimism over continuing economic growth in America, with Britain leading Europe in the GDP growth stakes at a projected growth rate of 3% this year. And finally there's the unknown, such as an unexpected world event or economic announcement. There is obviously no way we can factor these in to any outlook we might care to have for the market this Summer.

In summary, 'Sell in May' has some good historical data to back it up as an investment strategy. As outlined above, a decision to use it is dependent on consideration of whether you think you can do better over the Summer with your liberated cash, whether you think it might just be better to hold onto your stock regardless, or whether you will liquidate your holdings, forget about the stockmarket, and spend the time relaxing in your chosen stress free holiday hideaway.

Darren Winters 

Cold War 'The Sequel'

Crisis In Crimea

The Ukraine crisis appears to be anything but a storm in a tea cup. Not only has this crisis in the Baltic reshaped parts of the geographical map that borders with Russia but it is also unnerving smaller sovereign states bordering with Russia.  No doubt some former Soviet States are probably wondering whether they are going to be next in what is now a growing suspicion of Russia’s expansionary intentions.

The rapid increase in NATO troop movements near Russia’s borders underscores the escalating tensions between Russia and her bordering States. On Saturday 150 US troops arrived in Lithuania at the Lithuanian Air Force Aviation Base in Siauliai, according to Reuters. This recent deployment is part of a larger contingent of 600 troops that have already been deployed throughout Eastern Europe to reassure NATO allies. An additional company of soldiers arrived in Poland on Wednesday and in Latvia on Friday and more troops are also expected to arrive in Estonia today.  Equally, there have also been troop movements on the Russian side.  

Last month NATO’s top military commander expressed concerns about the buildup of Russian troops on the Ukrainian border. “Russia is acting more like an adversary than a partner,” stated NATO’s top commander.

The Ukrainian crisis is already reconfiguring NATO’s armies. Prior the crisis in the Baltic, defense officials held the view that large armies weren’t necessary to fight threats from terrorism, that military spending could be scaled down. In the age of austerity public expenditure on defense is a hard sell to a public weary of tax hikes and diminished essential public services.  

So a bloodless war, a cold war, maybe precisely what western defense makers may need to boost their lackluster sales.  If NATO armies are scaled up it means an increase in manpower that translates to the demand for more boots more rifles and more ships to cruise the seas   and planes to patrol the skies to protect us from the Russians. Even if this fear is illusory it becomes apparent that the defense sectors are going to be big gainers from the Ukrainian crisis.  

A conventional war with Russia would be unlikely-it would be MAD (Mutually Assured Destruction.)  MAD was the military doctrine behind cold war where both sides, the US and Russia, have the capabilities to destroy each other completely in a thermo nuclear war. So through terror, total annihilation, paradoxically we have had no major wars in Europe for the last 70 or so years.

The previous cold war between the West and the former Soviet Union was not only a period of heightened tension between the blocks but also a tremendous amount of competition, which had a huge impact on science and technology.  For example, the space race, the two superpowers competition in space exploration drove a lot of advances in aerospace and rocket technology. The humble remote control device that we all use to change TV stations in many ways owes its existence to guided missile technology.  So maybe a new cold war might also give the science and technology sector a new boost?  

However, there are a number of possible negative impacts that the Ukrainian crisis could have on the world economy.  Firstly, perhaps one of the most apparent fears is that the crisis might spark off of a trade war, which would almost certainly damage the global economic recovery.

Already US leader Barack Obama is planning to levy new sanctions on Russia. The US Presidents is also attempting to increase further pressure on Vladimir Putin, said Mr. Obama. There will be new sanctions on Russian individuals and companies in relation to Moscow’s alleged provocations in the Ukraine. The sanctions would include high technology exports to Russia’s defense industry, according to the US President. Over the previous week the US administration has been spearheading support in Europe for sanctions against Russia.             

But it has been a difficult call because Europe’s dependence on Russian gas means that it is not keen on the idea of sanctions that could deteriorate relations between Russia and Europe. Germany, the most dominant member in Europe is in no mood to rock the boat with Moscow, since it has no natural resources, and almost completely reliant on Russian gas for more than a third of its oil and gas needs.   Note, also that Russia is a large trading partner with Europe, exporting automobiles, parts while Europe imports Russian raw materials and commodities.

In view of the above, it would seem unlikely that Europe would willingly pass any sanctions with teeth.  Nevertheless, the Ukrainian situation is fluid and if the situations where to deteriorate further then Europe may have to come on board with more drastic sanctions.  

Assuming, the worst case scenario, that Russian troops walked into Poland, or say another NATO member, then Europe along with its NATO allies would be forced to take more severe measures against Russia.  Based on the NATO members’ agreement that an attack on one member is an attack on all-this could mean military intervention against Russia.

Assuming this unlikely event occurred Russia could retaliate by refusing to sell its oil and gas to Europe and instead sell it to China. This could have implications on energy security for Europe. Energy dependant countries like Germany would be adversely affected, unless they were able to source new supplies and the likely beneficiary here might be the Fraking industry.

Russia could also restrict grain sales to Europe, bearing in mind that the Ukraine is the bread basket of Europe. The reduction in grain supplies would result in a hike in world grain prices, food inflation for essential products like bread could spark off food riots in already severely economically depressed parts of southern Europe.

Indeed, commodities that do well during an economic and political turmoil would do better than other asset classes. 

In the worst case scenario Europe would be adversely affected, the EU may not survive a worse case scenario, resulting in the possible collapse of the euro.

In times of trouble there is normally a flight to the US dollar, gold and sterling.

Darren Winters

Ukraine’s impact on the stock market

The people of Ukraine have been going through a torrid time recently, with the escalating crisis continuing, but now the global world could be hit also with global markets being plunged into turmoil because of the crisis. There has been a spike in oil and natural gas prices that could reach into consumers’ wallet, just when the European economy was starting to pick up.

Despite these worrying revelations, and the fear that conflict could ensue in the East, analysts believe that there is little risk of global financial contagion or of major blow back to Western economies.

“If this turns into an outright war, it will be a different story,” said Holger Schmieding, the chief economist at the private bank Berenberg in London. He also went on to state: “More likely it will remain a Cold War-style standoff, and if that’s the case the economic damage for the West and the global economy will be limited.”

All this reassurance is not enough for some though, with many investors still feeling unsettled. This is on top of having been already shaken up about emerging-market economies. The main impact was obviously on Russian and Ukrainian markets, with the Moscow Micex index dropping 10.8 percent. The Ruble fell to a record low against the dollar, and there was concerns spreading to currencies in localised countries such as Poland, Turkey, and Hungary.

The concerning figures prompted the Russian central bank to announce a “temporary” 1.5 percentage point rise in its benchmark interest rate target, up to 7 percent. The central bank released a statement in conjunction with the change: “The decision is aimed at preventing the risks for inflation and financial stability arising from the recent increase in financial market volatility.”

Developed markets have also shown worrying signs since the outbreak of tensions also, with companies in exposure to Ukraine and Russia taking the hardest hit. The Euro Stoxx 50 index of European blue chips closed down 3 percent, and the Dow Jones industrial average lost 153.68 points, the equivalent to 0.9 percent. The NASDAQ composite index dropped 30.82 points, or 0.7 percent, to 4,277.30. These figures certainly prove that as long as tensions are still bubbling in the East, then companies in connection with that region are likely to suffer.

Investors have since moved into traditionally safer assets like US bonds and the Japanese currency. Elsewhere, European banking shares were altered by the situation, led by a 9.6 percent decline in Raiffeisen Bank International. This is huge in the world of banking as the Austrian lender is one of the Western leaders most exposed to Ukraine. Generally though, the fallout to the banking sector will be limited somewhat, due to the financial crisis in 2009, where many Western banks pulled back from Ukraine and Russian lenders.