There seems to be plenty of evidence suggesting that some players in the market have a significant advantage when compared to the average investor. While it’s legal, it also implies the market is hardly a level playing field. But this is OK. Individual investors can still profit from this rigged game, and they can even capitalize on big players’ advantages.
Are markets rigged?
Having greater access to information, greater access to powerful technology, and greater access to large pools of investable funds are significant advantages that virtually ensure stock market profits.
Recent reports about the University of Michigan’s influential consumer sentiment report and the Chicago purchasing managers index, a Chicago-based indicator of business activity, being released early to a select group of high-paying subscribers only confirms the benefit of getting information first.
The advantage of getting such information early is enhanced by the possession of highly advanced technology. High-frequency trading (“HFT”) firms are the main beneficiaries of such a setup. Armed with complex algorithms and super fast computers, they scour public and private markets for information that can cause deviations from historical price trends and leap on those discrepancies. These trading firms, made up mainly of scientists and software developers, hope to eke out a fraction of a cent profit on each of the huge number of shares they trade. HFT volumes are now estimated to account for 50% to 80% of all equity trades, up from an estimated 20% to 50% in 2006.
The evidence that an edge in technology and information creates an almost foolproof method of profitability is compelling. Many HFT firms have reportedly been able to make money on every single trading day. Large financial institutions, which also have access to huge pools of investable cash, add a market pricing influence advantage. The combination of these favorable traits seems to ensure big profits on a pretty consistent basis.
Leading financial firm Goldman Sachs Group Inc (NYSE:GS) reported trading losses on only 16 days in 2012, the fewest since it started reporting the figure in 2004. Morgan Stanley reported that it lost money on just 37 days last year, the fewest since 2007, and traders at JPMorgan Chase & Co. (NYSE:JPM) lost money on just seven days, down from 26 in 2011.
Unfair can still be profitable
Luckily the stock market is not a zero-sum game; astute investors can make money regardless of what hijinks go on with the big players. The keys for beating a rigged market are knowledge and a long timeframe. Knowing what a company’s worth and what information is relevant can offer a significant advantage over HFT’s and large institutions that trade based on recent headlines. Since these firms aren’t interested in a company’s fundamentals or long-term outlook, a correct interpretation of those factors can provide an edge for the individual investor.
Another advantage is having a long timeframe. HFT’s and most institutional players need to book profits very quickly. HFT’s often close out all positions daily and large financial firms need to meet quarterly or monthly benchmarks. The average investor, once having a reasonable basis for valuation, is able to wait as long as it takes for the value to be realized.
Profit from headline overreaction
The domination of short-term tactics in the stock market can often offer lucrative longer-term investing situations. Here are a few recent examples.
Health insurance companies often post negative surprises that cause a short-term overreaction. In July 2012, WellPoint, Inc. (NYSE:WLP)’s lower-than-expected earnings and reduced outlook sent the stock down sharply. The company reported that net income fell 8.3% to $643.6 million from $701.6 million a year earlier, though revenue increased to $15.2 billion versus the prior year’s $14.9 billion. WellPoint, Inc. (NYSE:WLP) shares plunged by more than 12% to $54 on the announcement.