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How to Get Rich Investing in Stocks by Riding the Electron Wave

Seven Golden Investor Rules To Keep You Safe in Today’s ‘New Normal’ Stock Markets

InvestorEducation / Learning to Invest Jul 15, 2010 - 06:12 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleShah Gilani writes: Pundits are talking about the "New Normal," a not-so-subtle hint at the sub-par growth that's expected from the U.S. economy.

Those pundits have picked the right book. But as far as investors are concerned they're reading from the wrong chapter. The "New Normal" isn't just about the economy. It's an epic story about not-so-great expectations - for the financial markets.


And - unlike its Dickensian counterpart - this tale doesn't have an especially happy ending.

A Financial Markets Fable
Understanding the New-Normal outlook for the stock-and-bond markets - and how those lessened expectations came to be - will help investors navigate the whipsaw markets of today. This, in turn, will show us how market insiders shape reforms - and will give public investors insights they can use to their own advantage.

Once upon a time, the U.S. capital markets were a place where financial professionals toiled away and created the debt-and-equity securities that corporations needed to fuel themselves and a growing economy.

Today, however, it's all about "product placement." Giant banking "factories" create new financial instruments that can be packaged and sold to investors around the world. Wall Street operates at its self-serving best, facilitating the placement and distribution of all these packaged financial products.

Trading was once a by-product of Wall Street's chief business - financing growth. But in the years that have passed, trading has emerged as Wall Street's chief product.

A "New" End Game
As the business of Wall Street has changed, what initially appeared to be mere unintended consequences came into focus as the actual end game that Wall Street intentionally engineered for itself.

It is these changes that investors need to understand in order to beat the Street at its own (end) game. The changes we're referring to are:

•The abolishment of fixed commissions.
•A shift to the decimal system for pricing stocks.
•And, the spread of competitive trading venues.
Doing away with fixed commissions was supposed to bring more competition and lower transaction costs for public investors. It did that. But, the consequence of increased competition was less profitability, especially for the big firms who dominated the brokerage business. The answer was to increase the quantity of available business by emphasizing trading over long-term investing.

Investors need to understand that the "game" has progressed so far now that trading takes precedence over investing. A long-term "hold" can be devastated by short-term selling - the result of trading strategies that may adversely affect the recovery period and net return of some investments.

The advent of decimalization was another Wall Street change that impacted the business dramatically. Stock prices used to be quoted in eighths. The smallest move a stock could make was one eighth of a dollar, or 12.5 cents. The minimum spread between the "bid" and "ask" of any stock used to be 12.5 cents. In order to lower transaction costs further, it was determined that the system of eighths be replaced with "decimalization," so stocks could move in increments of as little as one cent.

But while the narrowed spreads succeeded in reducing transaction costs, they also had an unforeseen effect: They provided a boost to market insiders, exchange specialists, and market makers, which ultimately made markets less liquid.

The term "liquidity" refers to the financial market's ability to move a meaningful volume of stock (or whatever instruments are being traded) without meaningfully moving the securities prices.

Under the system of eighths, if a specialist or a Nasdaq market-maker had an order in their "book" to buy 50,000 shares of XYZ stock for a customer at $50.00, and on the other side of the market a total of 10,000 shares were being offered for sale at $50.125, the "quote" would be displayed as: XYZ $50.00 to $50 1/8; 50,000 x 10,000.

A Rigged System?
Specialists and market makers have inside information because - as brokers transmit customer buy-and-sell orders to them - they see the "order flow" coming into their posts.

So if an order comes to a specialist's post to buy another 100,000 shares of XYZ stock at $50.00 per share, before anyone else knows that there is more interest in the stock, he would know. Given that information, the specialist might want to buy stock for his own account, which specialists and market-makers can do. In fact, trading for their own accounts is a much more lucrative business than just filling customer orders, due to the reduced commissions that they get now.

In order to buy XYZ, it used to be that the specialist would have to pay $50.125, because that used to be the minimum price increment of change.

With decimalization, however, if the specialist knew that there was about to be a total of 150,000 shares that buyers want to own, he could "step in front of" the $50 bid price and bid $50.01 to try and buy the stock for a penny more than the bidders already in line. If he buys stock at $50.01, he is only risking one cent per share, as opposed to risking 12.5 cents per share.

Since the specialist sees the order flow coming to him, if he saw that more stock was coming to his post to be sold and he realized the price was going to go down, he could turn around and sell the shares he just bought, up to 150,000 of them, to the bidders in line who want to buy at $50.00.

Specialists, market makers, and others with inside information do this on an increasing basis. And why not? Decimalization lowered their risk and increased their opportunity for profit.

It didn't take long for investors to realize that they were being "played" by insiders who would step in front of their orders and use them as a "backstop" to dump on for a small loss if their speculative positions didn't work out quickly enough. The net result is that big investors don't post sizable orders any more and liquidity dried up even more.

New Competition
Then along came trading venue competition. As public electronic communications networks (ECNs), and other trading venues began to compete with traditional exchanges such as the New York Stock Exchange, the AMEX, and Nasdaq, orders to buy and sell stocks got spread far and wide. The net result of all this competition has been a further dilution of liquidity as fewer and fewer orders are centralized in any one location.

Trade orders are spread around to different venues in part because competitors pay brokers and customers for their order flow, precisely to attract liquidity, and to have order flow to trade against.

Another advent of trading venue competition is the emergence of private trading networks for big institutional clients and trading places known as "dark pools." Taking big institutional order flow away from public exchanges dramatically reduces liquidity for smaller, public investors.

What's critical for investors to understand is that this dispersion of orders not only diminishes liquidity at any one venue, it diminishes liquidity across all markets. As spreads have become narrower and quotes "thinner" (fewer shares on any bid or offer), volatility increases exponentially.

Into the thin and spread-out markets, high-frequency traders (HFT) - well-capitalized professionals with armies of computers - not only step in-between the dispersed trading, they also use their computers to search for pending orders against which they will make very short-term trades. Trading by the HFT crowd is believed to account for as much as 75% of the trading volume on U.S. stock markets on any given day.

The Seven Rules for New Normal Markets
The push to make trading Wall Street's biggest money-making business, while narrowing spreads to reduce risk (especially for active professional traders), and simultaneously gaming the inside track by managing and trading against order flow, is the New Reality.

And for retail investors, that's what creates the "New Normal" - stock market returns that are much lower than the oft-quoted long-term averages of 10% or more.

To avoid getting whipsawed in the New Normal markets, investors need to copy the insiders who play the game they created with these seven New Golden Rules of investing:

1.Shorten hold periods for all investments, other than those "held to maturity."
2.Invest like a trader: Take profits regularly, and cut losses sooner.
3.Don't be afraid to step in front of standing orders by lowering your offer price a penny, or raising your bid price a penny, to get your orders executed.
4.Trade and invest where you can find the deepest quotes, meaning where volume is more substantial on the bid and offer side of quotes. More is always better. If your brokerage facility doesn't offer market quotes that are transparent, switch to one that does.
5.Whichever brokerage facility you use, find out what their execution policy is. They must have a "best practices" policy regarding execution. Make sure to get it in writing.
6.Ask what your brokerage's policy is regarding stop-loss orders. It is critical to know how they will handle the next "flash crash," when it comes. And believe us ... it is coming.
7.Complain about bad executions. It sounds cliché, but the squeaky wheel gets the grease. The pros squawk all the time, and sometimes they get better fills.
Understanding the New Normal is crucial. You don't want to get blindsided by what you don't know. It's critical to understand what might change with the advent of financial regulatory reform. The New Normal today may get old quickly.

But, if it does, you can be sure I'll do my best to expose any trap doors.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

Source : http://moneymorning.com/2010/07/15/new-normal/

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