Markets Gone Wild? What High Frequency Trading Really Means for Retail Investors

Eric Hunsader knew something was going very wrong as soon as the market opened on Aug. 1, 2012. As the founder of stock market data collection specialist Nanex, Hunsader knows what normal market action looks like. This was anything but.

At 9:35 a.m. EDT, Hunsader tweeted:


Trading exploded, and by 9:38 a.m. there were 14 stocks with trading volume higher than the S&P 500 SPDR (NYS: SPY) . As Hunsader put it in another tweet, "that never happens." The craziness continued, trading volumes continued to climb, and prices of some stocks swung wildly for no apparent reason. At 9:39 a.m., Hunsader fired off another tweet:

No halt ensued. At 9:55 a.m. the wild trading had still not let up and Hunsader lamented:

The computer systems at Knight Capital (NYS: KCG) had apparently taken on a mind of their own, erratically trading massive volumes of 140 different stocks. For nearly 45 minutes, Knight's systems blasted away, leading to $440 million in losses -- or roughly $10 million per minute of out-of-control trading. The losses crippled the company's balance sheet and, just like that, put one of the world's largest trading firms on the edge of extinction.

Jason Zweig at The Wall Street Journal and The New York Times' Joe Nocera were quick to characterize the turmoil as one more reason for investors to throw up their hands in disgust and exit the stock market completely. They were joined by numerous others, from Financial Times to Fox Business. If you subscribed to the prevailing view, you'd easily conclude that Knight's failure was a sign of a market completely out of control, and, furthermore, that it was a reason for individual investors to lose their last shred of faith in stock markets.

The apparently obvious conclusion isn't always the right conclusion, however. The trading glitch at Knight Capital did indeed represent failure on a massive scale. But this was a very different kind of breakdown than many of the other failures in recent memory, including the stomach-wrenching "flash crash" of 2010. As Ron Kruszewski, the CEO of eventual Knight investor Stifel Financial (NYS: SF) put it to us:

This event was different than the Flash Crash. ... The market worked. Capitalism worked. Knight took their loss. I can guarantee you that every firm that has computer interaction, including ours, did a thorough review of their system. In many ways, the market was a good regulator here. Knight was not the Flash Crash. That's very important to understand.

Nevertheless, watching one of the largest market makers nearly go out of business thanks to a computer glitch knocked many investors -- professional and retail alike -- back on their heels. Are unpredictable computer algorithms an inevitable part of the brave new world of investing? Do retail investors need to take special precautions in order to participate in today's stock markets?

Though "the market" may have done well in meting out punishment in the case of Knight Capital, this event highlights the need for investors to have an understanding of the structure of modern stock markets. In the series that follows, we take a closer look at the intricate plumbing of modern stock markets, while also highlighting some of the dangers that investors face. Throughout these articles, we'll suggest strategies that investors might use to protect their portfolio from risks associated with high-speed trading.

Of course, in order to really understand what went on, it's best that we begin at the beginning.

The article Markets Gone Wild? What High Frequency Trading Really Means for Retail Investors originally appeared on Fool.com.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook.Motley Fool newsletter services have recommended creating a bear put spread position in SPDR S&P 500 ETF. The Motley Fool has a disclosure policy.
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