Fat Finger? No Way

Display boards at the Australian Stock Exchange flash news of a falling market in Sydney, Friday, Sept. 23, 2011. Pacific sto
Display boards at the Australian Stock Exchange flash news of a falling market in Sydney, Friday, Sept. 23, 2011. Pacific stock markets are down sharply in early trading following big losses on Wall Street amid growing fears of another global recession. (AP Photo/Rick Rycroft)

Are you a "dumb investor"? Do you really think a "fat finger," i.e., a typo, brought about the glitch in the market last Wednesday morning? I've just finished a book called Dark Pools. It says NO WAY.

Have you yet realized that your pension fund or 401(k) is short, or likely to be short, of being enough to live on -- even with Social Security? Do you have any idea that's because wealthy traders are raiding your retirement funds?

Do you know that 70 percent of the stock market is now dominated by high-speed trading? These speed traders are "gaming" stock exchanges around the world and and cheating both you and your retirement plan managers out of billions, if not trillions, of dollars!

This is much, much worse than the Libor scandal.

Stock trading before the financial crisis

In 2006, I signed up for classes from Investools, the pioneer of investor education. Here's a story we heard often.

There are big ships in the water, i.e., "institutional traders," such as pension funds and mutual funds. And there are tiny rowboats called "retail investors," i.e., ordinary folks like you and me. It takes big ships a long time to "make a turn," i.e., buy and sell shares. Smart retail investors can turn on a dime and beat the big guys.

What our instructors and most other investors and traders didn't know was that the harbor was also filled with America's Cup racing yachts. These racing boats were invisible to others, and the rest of use were about to get swamped.

Investing before 2008

I began trading using Investools' method. It worked. I made money. Then one day it didn't work. I "stopped out" of the market. A few minutes later the price shot back up even higher than before, but I no longer held any shares.

Moreover, my brokerage sold my shares for a price far lower than the amount I'd set as my signal to sell. So I tried using "limit orders." These orders told my brokerage to sell only if the stock hit an exact price. But my brokerage ignored my limit orders. I asked the Virtual Reality Geographer to investigate. In a few days she returned with a theory.

"There are these wealthy traders who use high speed computers and some kind of algorithms. I think those traders are somehow causing the volatility of the markets to change quickly. My limit orders aren't working either," she added.

Disgusted, I cashed out of stocks just one month before the stock market meltdown of September 2008.

High-speed traders' "algo wars"

Three weeks ago the Virtual Reality Geographer found a book to confirm her theory. It's Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System by Scott Patterson.

High-speed traders' cheating started with algorithms, or "algos" -- human commands to computers. Conditional statements use the words "if" and "then" to identify the "condition" that will trigger a desired "action" by a computer. For example a limit order may say: "If the price hits exactly $49.97, then sell my shares immediately."

Speed traders "nest" conditional statements, one inside another, and hide them in their buy and sell orders. These statements can position themselves at the very top of the order queue of a stock exchange. This means traders' orders always get filled first. When price changes trigger these algorithms, the algos go off like fireworks on the Fourth of July.

The first statement tells the exchange's computer to buy low and sell high. But after buying, if the computer sees the price is going to drop, a second statement sells the shares, at the same price the trader paid, to one of the buyers stuck below in the queue. Other buyers get shafted, while traders lose no money -- EVER!

High-speed traders used inside information that Patterson's sources say the traders got from electronic stock exchanges themselves. Exchanges enabled traders to make sure their orders were filled while everyone else's wait. To quote Dark Pools, "Regular investors, the suckers using those stupid limit orders, buy high and sell low [i.e., lose money] -- all the time."

The losers aren't just retail investors, aka "dumb money." Managers of mutual funds, 401(k)s, private and public pension funds, governments, unions, and trading desks at banks lose money too!

How speed traders make billions

There's more. High-speed traders' algorithms also enable traders to make money on EVERY trade. These guys make money the same way brokers do. They collect fees that brand new electronic stock exchanges pay their "most-favored" customers, i.e., biggest clients, to trade with them.

Speed traders make a fraction of a penny in fees, paid by stock exchanges, for each of the quadrillions of orders that traders can execute within mere seconds -- while losing no money, ever.

Patterson's Dark Pools is not well-organized; the story is powerful, yet it could be a clearer; its index is way too short; and the darned cover on the expensive hardback bled purple on my fingers, but buy it anyway. You need to know what this book says!