Where's The Beef: Liquidity

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JAG
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Joined: Oct 26 2008
Posts: 2492
Where's The Beef: Liquidity

There is a common belief in the financial blogosphere that the year long rally in the stock, bond, and commodity markets is a product of Fed created liquidity. Dr. Martenson himself has frequently made the observation that a "wall of liquidity" has apparently hit the markets. A core belief for many gold investors is that the price of gold appreciates in unison with this Fed-induced liquidity.

In light of the brief stock market plunge that occurred on May 6th, 2010, I have to question the validity of this belief as it pertains to the stock market, and here is why:

The liquidity that has fueled this stock market rally is an illusion created by High Frequency Trading (HFT). What is HFT? Here is a brief description from WikiInvest's entry on the subject:

How does a flash order using HFT work?

As an example, let's assume that a buyer wants to buy 100,000 shares of INTC. The market price of an INTC share is $26.10, but the buyer's limit price is $26.40. In other words, the buyer is willing to pay up to $26.40 for each share of INTC or $0.30 more than its current price.[3]

Via flash orders fromNASDAQ, high-frequency trading firms get a peek at these orders for 30 milliseconds before they are shown to everyone else. Having detected a demand for INTC shares, the computers at these firms then start issuing small immediate or cancel (IOC) orders at specific levels above the current price of INTC shares. If the first sell order at $26.15 is accepted by the buyer, another sell order at $26.20 is issued, and so on.

This continues until a sell order at $26.45 is issued. Because the buyer's limit price is $26.40, the sell order at $26.45 is rejected. At this stage, the firms' computers flood the buyer with sell orders at $26.39, causing most of the company's order of 100,000 INTC shares to be filled at $0.29 cents above market price.

Under normal circumstances, a buyer would see the sell order at $26.15 and might subsequently drop the limit price on his/her order. However, high-frequency trading computers are so fast that unless the buyer owned comparable machines, he/she would have no chance to do this.

 

So basically, HFT trading programs derive their profit by using their speed to take advantage of the spread between the bid and offer for a particular stock. This strategy at first glance seems a little unfair to the sluggish biological traders in the market, but overall seems harmless to the market itself.  But what happens when you have HFT trading programs accounting for 73% of all equity trading volume in the US? From that same WikiInvest entry is the following observation:

On 24 July 2009, Karl Denninger of The Market Ticker[5] accused high-frequency traders of "intentionally probing the market with tiny orders [...] to gain an illegal view into the other side's willingness to pay. This pattern of offering [sell orders at different levels] was intended to do one and only one thing; manipulate the market by discovering [...] a hidden piece of information - the other side's limit price!" He went on to argue that "the presence of these programs [would] guarantee huge profits to the banks running them" and that "retail buyers would get screwed as the market [moved] much faster to the upside than it otherwise would."

Simply stated, we have a market that rises consistently on low volume days, as trading programs play hot-potato with stock prices amongst themselves. This HFT trading creates the illusion of massive liquidity in the market, but in reality only a small amount of money (relatively speaking) is required to achieve these gains in price.

Now on May 6th, the shut down of several HFT programs because of market volatility removed the bid from the market, causing the market to plunge. Within an instant, all that apparent market liquidity was gone because it was an illusion in the first place. Meanwhile, gold soared in the absence of this liquidity.

Where does that leave us? Ingesting another theoretical hamburger with no beef. 

Best....Jeff

 

 

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