Effective Volume Restores Market Visibility
The evolution of the trading environment during the last few years has put stock traders in an extremely dangerous position: they are at the mercy of computer trading programs, without the benefit of the market visibility that was available before decimalization.
Decimalization occurred in April 2001 and before that date, prices were quoted in sixteenths of a dollar. The change to one-cent increments made it easier for market participants to read the tape, but it caused two important changes:
- Before decimalization, the spread cost was 1/16th of a dollar, while it is now one cent. This means that many participants placed their orders in the book, waiting for prices to come to them. Those who urgently needed to buy stocks had to bid the price up at a “steep” one-sixteenth of a dollar. After decimalization, the cost to bid up the price became so low that it was no longer advantageous to put orders ahead of time in the order book. This drained the visible supply and demand from the order book. Because it is impossible to see the real supply/demand balance in the order book, it is difficult to gain market visibility without looking at the price changes.
- The second consequence is found precisely in this lack of visibility: institutional investors need to place large orders, but when the book size is thin, it becomes very dangerous to place such orders. New computer programs were developed to monitor the available liquidity and partition large orders into smaller orders that are released into the market. All the institutions now use these computer-controlled, order-processing algorithms. If we add to that the 20% of orders that come from automatic trading programs (black boxes), we can see that the individual trader is no match against powerful institutions that use exceedingly complex tools.
There are only two ways out of this: either we come back to “value investing” la Warren Buffet, where earnings and cash flows are the rules, or we restore visibility in the system.
How to restore visibility in the equity markets
There is a rather simple way to detect institutional players’ fingerprints as they accumulate or distribute shares: since there are only 390 trading minutes in one trading session, a large player needs to buy.