Roller coasters can be fun. The ride's loops, ascensions and plummetings are exhilarating because the riders know they won't get killed and at some point the ride will come to an end.
However, the roller coaster ride that the stock market took last week was far from enjoyable. Unlike the rides at the theme park, the ride could get dangerous and last too long.
On Thursday, Aug. 4, the S&P 500 fell 4.8 percent. The U.S. debt was downgraded over the weekend, and the following Monday the market fell another 6.7 percent, followed by an increase of 4.7 percent the next day. On Wednesday it was back down 4.4 percent and on Thursday a rebound of 4.6 percent. Friday was relatively calm, as the market rose only 0.5 percent.
Last week's market activity set records. According to Credit Suisse Group, equity volume from Aug. 4-10 was the greatest for any five-day period, 15.97 billion shares. This number is twice the daily average of shares traded in the first half of 2011,
and even bested the previous record which was September 2008 when Lehman Brothers filed for bankruptcy.
High-frequency traders
Many cite the emergence of high-frequency traders as the primary reason equity markets have become more volatile in recent years. HFTs use computer models, referred to as algorithms, to identify and exploit price discrepancies and market momentum.
They have no interest in the fundamentals of the underlying companies, but rather these mathematicians use their computer models to sift through massive amounts of data to uncover the smallest of price discrepancies and profit from it.
According to research from the Tabb Group, HFTs account for as much as 53 percent of daily equity volume, up from 26 percent in 2006. For August, however, HFTs are estimated to have made up 75 percent of all U.S. equity trades, according to Wedbush Securities, the largest broker on the Nasdaq stock market.
HFTs have come under suspicion since the May 6 "flash crash," when the S&P 500 fell 6.2 percent in a 20-minute span before recovering to finish down 3.2 percent. On that day, 19 billion shares were traded.
A report issued four months later by federal regulators claimed that the operation of HFTs, amid other factors, contributed to the rapid plunge in market value. Mysteries still persist, but it's generally understood that HFTs, trading millions of shares per second, shut down their trading once the market dropped to a certain level. The result was a rapid decline in liquidity -- no buyers for the multitude of sellers -- and a market rout ensued.
Regulating traders
In 1998, the Securities and Exchange Commission changed the rules that would allow alternative trading systems to become self-contained stock exchanges. These alternative trading systems create a market: buying and selling on a computer-automated system, in the same way individual specialists run a book on the NYSE.
But unlike human specialists, the HFTs trade with such speed that enormous quantities of stocks are moved in a fraction of a second.
Others believe HFTs go beyond the innocuous activity of profiting on a tenth of a cent price difference in a security.
Many market commentators believe that HFTs perpetrate "flash trading" and a practice called "spoofing." Flash trades essentially allow the HFT to look at the other player's cards milliseconds before a trade. Through a process of rapidly placing and then canceling orders, HFTs can identify the other party's limit price, thus manipulating the system.
Spoofing involves placing a large amount of trades on order books in order to mislead other market participants in the direction of the market or its liquidity.
Familiar standards remain
What does this mean to the average investor?
Fundamentals still matter. Investors that buy the stock of companies based on their fundamentals -- growth, profit, margins, market share and innovation -- should not be affected over the long haul.
Companies with strong leadership that provide quality products and services will increase in value over time.
But volatility in the market will likely increase because of the proliferation of HFTs. The key for a long-term investor is to remember not to panic when markets behave irrationally.
Travis Flenniken is vice president of investments with DeMoss Capital.