Author: Lelio Vrancovich
Covestor model: Technical ETFs
After witnessing yet another debacle in the markets early this month — this time the spotlight was on Knight Capital Group (KCG) — I started thinking of how high-frequency trading could be used to the advantage of the small investor.
First, let’s recall what actually happened that day.
KCG apparently runs computer code to trade stocks. Some of the computer code malfunctioned and this caused KCG to run up the prices in many equities.
The issue was identified and resolved in about an hour. But by then, KCG was the proud owner of several billion-dollars worth of stock at inflated prices that could not easily be liquidated without causing further price erosion in the markets.
That caused an immediate capital shortfall and a possible bankruptcy if capital could not be raised quickly.
As part of the solution, Goldman Sachs stepped in to buy the securities from KCG – probably at a discount — and then the company rushed to the market in search of a capital injection of about $400 million.
The money was made available by a consortium that was probably more interested in keeping KCG afloat in order to protect their own interests.
The price for the rescue was very steep; KCG had to give away 70% of the company in exchange for the rescue package, effectively diluting existing shareholders by a factor of 3 to 1.
What’s the takeaway?
For starters, stop losses should not be used by investors; they won’t do you any good. It makes more sense to buy more shares if prices are lower rather than selling them.
Another way we can benefit is by placing buy limit orders well below market prices for stocks you wish to own, or to place sell limit orders for stocks we already own well above market prices in hopes of catching a high-frequency-trading-induced price spike.
To many, the plan might sound like a pipe dream. But it happened to me the morning of the KCG debacle. My shares of Bridgepoint Education (BPI) went up by 15% and then settled back down. I don’t know that BPI was held by Knight, or was simply caught up in a rising tide.
BPI is not a stock I would be willing to let go for a 15% gain, but most others I would.
As far as my portfolio goes, I continue to expect a surge during the fall period. Prices are up considerably in early August and I hope that we will be showing a profit by early September.