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The case for and against Schumer’s “flash trading” ban

By Bando Bucks, August 11, 2009 under Finance

A lot of talk in recent days has been about so called “flash trading” in the stock market, led by Democrat Sen. Chuck Schumer (NY).  Flash orders aren’t universally defined, but I’ll simply describe it as “not showing” your bid or ask on the tape before you make a trade (i.e your order is routed and executed at a maximum of a half second).  Because tape reading is an ancient craft and the sending of market orders is a regular part of stock trading, I’ll focus more on computer generated trading to show some of the disadvantages of flash trading to the ordinary (even professional) trader and investor, but also to explain why it’s important to the market.

This type of flash trading in a nut shell is the automatic, electronic trading of stocks typically using a quanitative approach to placing trades within fractions of a second of prevailing market data.  For example, years ago when an important economic report was released to the public, traders and investors would receive information and then place trades amongst each other.  Much like in the movie “Trading Places” when the crop report was released, all hell broke lose on the floor of the commodities exchange to make trades based on the information at hand.  In recent years, there is no such trade for ordinary investors, even guys like me who can hit a single button on a keyboard to execute a buy or sell (some would also call this flash trading).

Instead, trading of that information is dominated by computer programs set up by the likes of big firms like Goldman Sachs, and small quanitative shops you’ve never heard of.

On Friday, I watched the jobs report come out, and instantaneously after the number hit the Bloomberg tape these programs bought the S&P up 6 points.  I had no chance, and I use some of the most sophisticated stuff out there.  A program could be set up like this:

IF change in payrolls = >-355k, sell 1000 SPY, sell 1000 XOM.  etc…

And it happens before any typical trader, mom and pop trader, etc even has there hands on the information.

Here’s another example of computerized flash trading:

If Crude Oil ticks higher +.15%, buy 1000 XOM

Firms spend billions a year on technology and highly sophisticated staff to make these programs.  They essentially hit a button in the beginning of the day, and the machine does all the trading.

This all seems a bit unfair, right?

Well on the other end of the argument is a liquidity question, and how flash traders and programs help the market function perfectly.  In a recent study, 50% of all market volume comes from flash traders, a lot of it from these quantitative shops.  That is a LOT of liquidity added to the market, helping traders and investors have ease of access to trade the market.  The bid for ExxonMobile right now is $68.58, and the offer is $68.59.  That is a perfect market for XOM stock.  If you wanted to purchase the stock you will be paying a 1 cent premium to the bid.  Half of this liquidity comes from flash traders and the immense amount of volume they do.  If there was a flash trading ban, the spread (difference between bid and ask) could be what it was before penny’s were introduced, perhaps equal to the spread of the old fractional method.  The new bid/ask for XOM could be as high as $68.54/$68.62, making it difficult to receive a good price and trade in a perfect market.

It seems of late that Schumer and other politicians are focusing too much on “fairness,” and not enough on the forces that drive the stock market and make them as perfect as they are to trade.