Revenge of the Nerds (Part Deux) - 06/10/10

"I say we blow the XXXXers up."

-- Dudley "Booger" Dawson (Curtis Armstrong), Revenge of the Nerds

Those nerds, who worship at the altar of price-momentum-based algorithms are a threat to our way of life.

I am acutely aware that the market faces an onslaught of fundamental threats and the meltdown in BP's (BP) shares in the late afternoon certainly muddied up the market's waters.

Some of these fundamental threats represent reality; others are based on the perception of reality. But the better market tone established after a leak of a strong Chinese export number (confirmed last night) should have enabled the market to build off of an oversold and to sustain Wednesday's morning's market rise.

Once again, though, based on my contacts with the sell-side institutional trading community, high-frequency traders, catching a slight break in price momentum in the averages, ran rampant in the last 45 minutes of trading yesterday. (Jim "El Capitan" Cramer discussed the technical selling last evening in his final column.)

Possibly in support of the view that high-frequency traders are artificially influencing (manipulating?) stocks, just look at the sharp rip in the S&P futures overnight (up11 points).

One cannot overstate the erosion in investors' confidence (both of individuals and institutions) that these programs are causing on a regular basis. In part, the existence of these programs explain why 22 of the last 30 trading days have recorded triple-digit DJIA moves.

Over the past month, I have frequently written about the deleterious impact of high-frequency strategies on the markets in "There Is No Business Like Mo Business," "Revenge of the Nerds" and "Kill the Quants Redux."

Many subscribers have asked me to recommend how regulatory authorities can remedy high-frequency trading's impact on the markets.

So, here are three basic rules that I would immediately implement for the purpose of halting the outsized impact of momentum-based high-frequency strategies that occur in the vacuum of hedge fund de-risking and in the absence of retail domestic equity inflows:

1. Institute a transactions tax. While I hate this idea, it would immediately and dramatically increase the costs to high-frequency traders and reduce the incentives and edge of many price-momentum strategies).
2. Bring back the uptick rule for shorting. This short-sale rule was eliminated in July 2007 -- its original purpose was to prevent traders from being able to force prices downward. Bring it back!

Disallow the ability of high-frequency traders to see order flow and to discover stop levels.