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October 12th, 2009
The victims of high-frequency trading
Even with all the fuss over high-frequency trading, there has been too little focus on how retail investors can get fleeced by Wall Street’s superfast computer-driven trading programs.

Brian Watson’s story is one that both ordinary investors and regulators should heed.

On April 28, Watson was caught in a freak trading storm as shares of Dendreon plummeted 69 percent in 70 seconds. The Seattle biotech’s stock plunged to $7.50 from $24, as the company got ready to provide investors with an update on its experimental prostate cancer treatment drug.

In little over a minute, the equivalent of an entire day’s worth of trading activity in Dendreon’s shares took place before the Nasdaq stock market halted the stock.

By then the damage was done. The lightening fast selling triggered a so-called stop-loss standing order Watson had with his broker to sell Dendreon shares if the stock fell into the low $20s. But the stock fell so fast that the broker didn’t actually sell Watson’s 1,500 shares until the price had hit $15.

Watson forfeited $18,000 in unrealized gains and absorbed a $1,500 loss. Now that may not sound like a lot. But it’s a bitter pill to swallow when you consider that Dendreon shares quickly rebounded from their pre-crash level after the company reported generally positive test results and trading resumed.

And Watson is not alone. A similar thing happened to Brett Burdick and anecdotally to many other retail investors who had placed stop-loss orders with their brokers on shares of Dendreon.

There has been speculation that short sellers, traders who look to profit from the stock’s plunge, spread a rumor that Dendreon was going to report poor test results for its cancer-fighting drug. Others theorize that a broker incorrectly typed in an outsized sell order, which panicked others in the market.

But no matter what the precipitated the sell-off, it’s likely that high-frequency trading magnified it-given that these automated trading programs control more than half of the daily stock trading in the United States.

Some of the algorithmic programs that drive high-frequency trading desks are designed to spot an unusual trading trend — such as a sudden decline in a stock’s price-and jump on it. Other programs, meanwhile, are written to automatically cancel bids to buy fast-falling stocks in order to minimize losses.

“If an HFT guy steps away from a stock, that can drive it down,” says Joe Saluzzi, a co-founder of Themis Trading in Chatham, NJ and an outspoken critic of superfast computer-trading. “It’s not necessarily the shorts pressing a stock down, it’s also because of bids disappearing.”

It’s all perfectly logical from a trading perspective. But when these two strategies come together, it can create a vacuum-like force that allows a stock to plunge in a short span of time. This is the kind of unintended systemic shock to the markets that has got critics and even some advocates of high-frequency trading nervous.

It is one reason, as my Reuters colleagues Jonathan Spicer and Herbert Lash pointed on Oct. 9, that a small group of high-frequency traders want to create a market-wide monitor to be on guard for malfunctioning computer trading programs.

Yet it’s not clear securities regulators are sufficiently worried about the potential systemic risk posed by high-frequency trading. And that should worry everyone.

When regulators talk about high-frequency trading they often focus on seemingly obscure things like whether traders should be able to put their computers close to the stock exchange to maximize trading speed, or buy and sell shares through less-than-transparent “dark pools”. These are all important issues, to be sure.

Yet they pale when compared with the threat of a high-frequency trading program sparking a sudden and inexplicable sell-off in a stock.

That’s why it’s imperative for regulators to come clean with what, if anything, they know about the events that led to the April 28 debacle in Dendreon shares.

It’s been five months since that event, and investors are entitled to answers.


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