Two Simple Strategies to Build Your Confidence

It appears for a second - then vanishes forever.

I'm talking about something called a "ghost order." It's when an institutional trader - or computer trading by proxy - enters an order and immediately cancels it.

Even though stock orders are frequently submitted and then cancelled, order books still record the event. And these order books are now being increasingly scrutinized to see if they represent an unfair advantage created by those placing the order.

As if high-frequency trading firms need another advantage. Let's face it - they already have wires that directly connect their computers to those on the major exchanges in order to have the fastest order routing.

The practice by high-frequency traders to place and cancel orders in milliseconds has come back under scrutiny by the U.S. Securities and Exchange Commission (SEC), and for good reason. These traders, who typically make up the majority of trading volume in any given day, wield incredible power.

If you didn't read about this earlier this week and recognize it for what it is - a discussion of the fundamental operating structure of publicly traded stocks - then you absolutely need to read on.

Everything I'm going to say directly relates to how you buy and sell small cap stocks - and other securities for that matter, so even if I start techno-babbling, fight through your desire to gaze out the window and dream of what you'll do this weekend to celebrate the official end to summer.

You need to understand how our electronic markets work, or at least how they should. If you have this knowledge, you can recognize great buying opportunities, and also recognize when the market is trying to suck you in, take all your money, and spit you out.

"In the old manual market structure, the market participants with the best access to the markets -- the specialists and the dominant exchanges -- were subject to significant trading obligations," said SEC Commission Chairman Mary Schapiro in Bloomberg Businessweek. "These traditional obligations have fallen by the wayside."

The question is how to regulate those with the best access to the markets. While Schapiro recognized that, "There may, of course, be justifiable explanations for many canceled orders to reflect changing market conditions," U.S. Senator Charles Schumer counters: "When thousands of orders are sent and canceled in a fraction of a second, it is clear that those orders were never intended to be executed."

They're both doing the dance, suggesting that this practice needs to be looked at but recognizing that a dramatic re-tooling of the current order entry system could be disruptive to markets, especially since the consensus - established long before this debate ensued - is that greater liquidity in markets leads to more precise price discovery.

Now I could go into the definitions of transparency that institutions like the Financial Accounting Standards Board (FASB) suggest to help determine fair value. These differentiate 'quoted prices', from 'observable values' from 'unobservable values'. These accounting terms are used to determine fair value for financial instruments with varying levels of liquidity and transparency.

I'd like you to finish reading this letter so I'll sum it up in one sentence.

Fair value is what you can get for something you want to sell - period. The more buying and selling that occurs, the more accurate the price. This concept is what spurred the move toward electronic trading. And I think the concept is sound.

But "High-frequency traders claim that they benefit the markets by providing significant additional liquidity...Much of the supposed liquidity is not real," says Schumer.

After the May 6 'flash crash' the SEC has tried to implement trading stops on stocks that move too far, too fast. One of the things that happened on that day was that stub quotes, which are orders that brokers place in the market to fulfill their stated obligation to buy and sell stock, went through for fractions of what the stock had been trading at just minutes before.

Bloomberg reports that on May 6 the "selloff erased $862 billion from the value of U.S. equities in less than 20 minutes. A preliminary report published in May by the SEC and the Commodity Futures Trading Commission found liquidity dried up when it was needed most."

So we put this problem behind us right? Well, not quite.

On Tuesday of this week shares of Nucor NUE triggered a trading halt on the CBOE when a 100 share order went through for $0.01, a far cry from the mid thirty-dollar price the stock had been trading at just minutes before.

It was a case where "the incoming large market order simply walked our book down to that last order," said David Harris, the president and chief executive of CBSX.

This discussion is far from over as the SEC will continue to review the practice by trading firms to place stub quotes.

In the meantime, what should we do to position ourselves to take advantage of fast moving markets and protect our capital at the same time? Two things:

First, use manual stop losses for your stocks. What I mean by that is don't have a stop loss order placed in the market - if you do and a stock 'flashes' down, you could be closed out of the position when you really didn't want to be.

If you have a manual stop which the stock closes below at the end of the day, evaluate the position and sell it the next trading day. This gives you the chance to evaluate what is truly going on with the stock - not just what is going on with the electronic order process.

Second, do the exact opposite with buy orders. Have buy orders in for the stocks you want to buy at prices far below the currently traded price. These are your dream buys - I'm talking 20, 30, even 50 percent or more below the currently traded price. If the stock flashes down, you may have your order filled and pick up shares in a company that essentially went on sale for one day.

Both of these strategies will help you feel more confident about how you buy and sell stocks because by following them you're recognize the reality of the situation - and both protect yourself from abnormalities, while taking advantage of them. In short, you're aligning your interests in a way that takes advantage of the inefficiencies inherent to how the market operates.

I use both of these strategies in Small Cap Investor PRO and Ian Wyatt's $100K Portfolio, saving subscribers from selling stocks that have rebounded above my manual stop-loss in intra-day trading. I've also picked up shares of stocks in Ian Wyatt's $100K Portfolio when they fell to a level at which I had already decided I wanted to own them.

Try these strategies out - they might not work today, tomorrow, or even next month. But when they do, you'll feel more like a Wall Street Insider who's in control of your own money than like a home-gamer who's getting played by the big dogs. It'll increase your confidence, and your returns. At the end of the day, that's what it's all about.

Check out Small Cap Investor PRO here and Ian Wyatt's $100K Portfolio here. And let me know how you feel about these stub orders, and high frequency trading. Are you in favor of it or against it? Write to editorial@smallcapinvestor.com.