Everybody knows that retail and institutional investors are usually late to a trade. When they decide to buy, the wise guys are distributing or selling their shares to them and locking in their gains. When they sell, the wise guys are accumulating or buying their shares from them, again locking in their gains.

How do the wise guys pull it off? The answer lies in the combination of reflexive human behavior and the use of high frequency, algorithmic (HFA) trading. With the advance of computer trading on a massive scale, large investment banks and hedge funds, which have huge amounts of cash at their command, are able to manipulate the markets almost at will. They use the speed and efficiency of computer-driven trading to move stocks in the direction they want. They do this by boosting the volume traded in a target company by buying and selling almost the same number of shares at extremely close time intervals. For example, in a buy-then-sell program, they start the trading sequence in a certain stock by buying slightly more shares than they sell at intervals of a few seconds or less. In other words, they are initially net buyers. Note it does not take very much time to establish a huge position in a stock when trades are executed so rapidly. The increase in volume invariably attracts investors, who pile into the same trade thinking there is some positive development at the company. This large influx of net buyers moves the stock higher just like the HFA traders intended. The HFA traders then simply assist the upward momentum they initiated by maintaining their buying and selling at the same level or net neutral while the shares they initially bought increase in value as investors enter the trade at a higher price. At a certain point, the HFA traders are satisfied with their short-term return and become a net seller to late investors, thus locking in their profits and closing out their position. HFA traders can reinforce the head-fake and compound their ultra-short term gain by simultaneously executing the same buy-then-sell routine in the option markets. They would simultaneously manipulate call options on the target stock in the same manner, which effectively turbo-charges the deception. The same sequence of profitable trading in the reverse direction can be realized from short selling. HFA traders can modulate the size and frequency of their wave trades algorithmically to attract investors and, thereby, maximize their return. The algorithms used by HFA traders are variations of simple software routines. (Input the target company; buy price points and volume; and intervals between purchases. Monitor stock price feedback. As the price moves up, scale back purchases and then start selling at a higher price level to collect a quick profit.) HFA traders have perfected algorithms to make these trades automatically. As a result, they can manipulate the market to their advantage any day of the week. By moving their servers adjacent to the exchanges where they trade (a process called collocation), they reduce the time it takes to execute and confirm each trade. The only difficulty is trying to make their gains not appear so obscene that they attract the wrath of the investors who are their victims.

The analogy would be a wave initiated by students at a ballgame. See link: www.youtube.com/watch?v=3NxLh-3DdaE. The students start the wave just like the investment bankers do at their trading desks. Once the wave starts, it has a life of its own until it peters out. By the time the wave goes one full circle, it takes fewer students to keep it going. The students spent the biggest amount of energy getting the wave started. After the first full cycle, more and more students can sit down and watch the results. The same is true with HFA traders. They get the trade started with assistance of large-scale, high frequency computer trading and a big slug of capital. Once the wave grows and achieves critical mass, they take their profits off the table. In short, HFA traders ‘head-fake’ their way to massive profits and they can do so anytime they want.

The discussion above describes exactly how HFA traders manipulate the market to ‘earn’ huge profits at will using high-speed computer trading, large sums of money, and reflexive human behavior. It is like the elephant in the room that no one can see, except the HFA traders who are hauling in huge profits. The beauty of the strategy is that HFA traders can head-fake and rip-off a few cents from investors on each trade (which is multiplied by huge volume) and will not be noticed. It is the perfect scam, which insidiously undermines and makes a mockery of our capital markets. No wonder HFA computerized trading makes up more than 70% of the daily volume on our equity exchanges. Traders using HFA computerized trading defend the practice under the pretense that it makes for a more efficient market, but in reality, it simply permits them to steal more efficiently from investors every day of the week. They and they alone are served, while all other investors pay higher prices for the shares they purchase on what is supposed to be a fair and open market. In the first quarter of 2010, several large investment banks reported gains every single trading day, which is statistically impossible unless you are cheating. It is so simple a cave man can do it. Such market manipulation is destroying the underpinning of our capital markets. The recent outrage about HFA ‘flash’ trading is just the tip of the iceberg. The far more lucrative and insidious form of HFA trading is the wave, which is high-tech pumping and dumping at its finest. If HFA traders can move a company’s shares in any direction they desire, they can move an entire market in any direction they desire. For example, HFA traders can concentrate on a small group of companies within the 30 stocks that comprise the Dow Jones Industrial average to move the average higher. The broader market indices, like the S&P 500 and the NASDAQ, usually move with the Dow and would go higher as well. The implications are enormous for the integrity of our capital markets.

HFA traders at large investment banks and hedge funds have the means, the methods and a strong incentive to exploit investors and have been doing so for years under the radar. In fact, it would be remarkable if they did not do it because the Securities and Exchange Commission has shown no inclination to investigate and prosecute such practices, which are clearly fraudulent under the provisions (Rule 10b-5) of the 1934 Securities Exchange Act. Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency. Clearly, the wave conforms to this definition. With the SEC sitting on its hands, the door is wide open. HFA trading is growing exponentially and exchanges are expanding their facilities to make room for HFA traders’ equipment.

There is much talk about the Plunge Protection Team – PPT. The government does not have to enter the market directly to prop it up. They have surrogates at Wall Street investment banks and hedge funds that act as blowout preventers to forestall or mitigate huge drops in the market. In exchange for keeping the market from crashing by use of high frequency computerized trading, Wall Street firms are permitted to keep their huge profits without suffering any legal reprisals. The SEC simply looks the other way. Government officials benefit when the Wall Street firms kick back a small portion of their obscene profits to fund political campaigns.

The aforementioned plunge protection scheme is not foolproof by any means and could backfire at any time. If some unexpected event or series of events should trigger an avalanche of sell orders, market manipulation to the upside would be overwhelmed and rendered useless, causing HFT traders to step aside and withdraw their bids. Because they control over 70% of market volume, the paucity of bid orders would leave the market vulnerable to a precipitous fall. The so-called ‘flash’ crash last May was a preview of what could happen again under such conditions. The result would be severe losses for investors.

Computers and simple software algorithms are replacing and mimicking the old ‘pump and dump’ techniques, which unethical analysts had previously carried out verbally or in writing. In the wake of the dot com bubble, those abuses were exposed for all to see. Now analysts are required to disclose when they have a stake in a company they are touting. One door had closed, but another door opened. High frequency computer traders are faceless and do not have to disclose anything. They can cheat and steal with impunity. No one is watching and no one seems to care. The wise guys always win.