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TheStreet Open House

Make Volatility Your Friend

Stock quotes in this article: KCG, FB

NEW YORK ( TheStreet) --The investing public isn't feeling so great these days about the stock market or the financial industry in general, and last week's trading snafu by Knight Capital Group (KCG) was the latest log to fall on the bonfire of mistrust that is engulfing Wall Street.

The blaze is also being stoked by all the usual vanities, to borrow a phrase from the great Tom Wolfe.

"We need new regulations!" say the politicians. "The game is rigged!" cry the pundits. "Will Knight survive this fiasco?" wonder the speculators.

I think everyone needs to take a deep breath. Let's review what happened here.

Knight is a market-making, electronic execution, and institutional sales and trading firm that used to be the largest trader of U.S. stocks on Wall Street with a market share over 17% on the New York Stock Exchange.

Last Wednesday, a technical glitch in its proprietary trading algorithms caused sharp swings in a handful of stocks, which ultimately cost the firm $440 million... oh, and its reputation.

The episode was a mini-reprise of the so-called "Flash Crash" that rocked the markets back in 2010 when the Dow Jones Industrial Average suddenly dropped by more than 1,000 points for no apparent reason, only to recover within minutes. That episode brought the rise of high-frequency, computerized trading to the public consciousness, and it too set off a temporary bonfire of the vanities that ultimately resulted in... well... nothing really.

Last week's debacle also reopened fresh wounds from Facebook's (FB) disastrous initial public offering, when some investors experienced trading glitches on the Nasdaq, but what do we really expect here? Do we think that in this age of digitization, computing power will not transform the way our financial markets function?

Assuming the answer is no, then do we actually think there won't be glitches and mistakes resulting from this? In this case, Knight paid a dear price for its transgressions: The value of the company plummeted, it lost huge amounts of business and it suffered damage to its reputation damage that may be irreparable.

"We screwed up," Knight's CEO Thomas Joyce said on CNBC early this week. "We paid the price."

I don't mean to minimize these events or the broader concerns they raise. Certainly, it's disconcerting that high-frequency, automated trading now makes up the vast majority of the trades that are placed on our major financial exchanges. The robots took over our financial markets before most of us really understood any of this.

Regulators surely have a responsibility to respond to this development swiftly and sensibly (yeah, I'm not holding my breath either). Computerized, high-frequency trading has fueled the hyper-short-term mindset of the financial industry, adding to valid perceptions on the part of the public that Wall Street has become little more than a glorified casino, and its major financial institutions that now enjoy back-stopping from the federal government also have an unfair edge in the markets, enabling them to pile up quick trading profits off breaking news.

That's bad news for investors that try to play Wall Street's game of actively trading in and out of stocks or options or funds in an effort to time the market and rack up trading gains over time to grow their accumulated wealth. Such an exercise would be quixotic even if the marketplace was a level playing field. Under the circumstances, it's certifiably insane.

As I've argued numerous times before in this space, the proper method for investing in stocks is to buy equity in companies that you have good reason to believe are underpriced and have bright prospects for increasing their profits over time.

Then, you should hold onto such stocks for at least a few years, ignoring the short-term, manic mood swings of the market and minimizing the fees and taxes that you pay along the way. That is the road to outsized, long-term investment returns for the investing public.

If you play that game, then what is the harm of a "Flash Crash"? Chances are, such an event will be over before you even hear about it. If not, you may have a rare opportunity to buy a stock that you like at an extraordinarily low price, or if the robots should happen to trade a stock you own way up, it may result in a golden opportunity to sell. What's wrong with that?

Most people are scared by this volatility, and you can take advantage of that by acting rationally. When you view things from the perspective of a value investor, then market volatility -- which causes securities to trade above or below their intrinsic value -- suddenly becomes your friend.



Follow me on Twitter @NatWorden

At the time of publication the author didn't own any stocks mentioned in this article.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage. This contributor reads:
The Oil Drum
The Baseline Scenario
I Want Media
Zero Hedge
Gregor Macdonald
Chris Martenson
On Twitter, this contributor follows:
Doug Kass of TheStreet
Jesse Eisinger of Pro Publica
Daniel Alpert of Westwood Capital
Barry Ritholtz
Joshua Rosner, managing director of Graham Fisher & Co.
Bob Lefsetz, a music industry blogger

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