Streetwise Professor

May 6, 2010

There’s Computer Trading and There’s Computer Trading

Filed under: Economics,Exchanges — The Professor @ 6:26 pm

One story circulating to explain today’s selloff is a large, mistaken order entry by Citi.  Certainly not outside the realm of possibility.  It’s happened before.  There’s the famous story of the MATIF trader who swung around in his chair to speak to a colleague, and unwittingly rested his elbow on the “Sell 100” key on his trading keyboard, triggering a deluge of sell orders that caused the market to tank before he realized his mistake and started buying furiously.  Or the case of the guy who thought he was in the training mode of the Eurex system, when in fact he was in the live trading mode; he was goofing around, submitting big orders into the “simulated” market that were in fact going into the real market and causing the price to go crazy.  As I recall, this cost his employer (a German bank) $150 million.  Or the error in Japan where somebody submitted an order at a price that was off by several orders of magnitude.

So yes, stuff like this can happen in computerized markets, although systems are being made more robust to these kind of errors.  More robust, not completely so.

And, perhaps, once the original mistaken order went in, and affected prices of Dow stocks, that triggered other programs that caused additional selling.

But I am highly confident that the near immediate snap back was also computer driven, as other algos’ signals indicated that the new prices were too low and submitted buy orders.

The post mortem will be interesting.

The terms “program trading” and “computerized trading” are used so much it’s worthwhile distinguishing the problematic kinds from the beneficial ones.

Computerized trading was widely believed to have exacerbated the 1987 Crash.  The order execution then wasn’t computerized, but portfolio insurance strategies made order submissions contingent on price movements according to a computer algorithm, so the trading was computerized in some relevant sense.

This is the kind of automated trading that is problematic because it can create destabilizing positive feedback effects.  Synthesizing index puts as portfolio insurance through a dynamic trading strategy means that big price declines triggered more sell orders that arguably exacerbated the price declines which caused additional sales, and so on.  Option hedging strategies (e.g., dealers use dynamic hedges to manage the risk of options they’ve traded with customers) can have the same effect.

Stop orders (which probably contributed to what transpired today) can have a similar effect; price declines (rises) trigger sell (buy) orders that can exacerbate price moves.  These kinds of orders are as old as the market.

Margin-driven trades can do the same: those suffering losses on a price decline (increase) sell (buy) and who cannot come up with the necessary margin sell (buy) to close positions–again, as old as the market.

Some computerized trading–and I would argue that most algo trading–is very different.  It is a negative feedback strategy.  That’s what market makers do: they sell into purchases and buy into sales.  Much algo trading is effectively automated market making.  It is, in effect, the realization of what the great Fisher Black imagined in 1971, when he wrote an article in the Financial Analyst’s Journal titled “Towards a Fully Automated  Stock Exchange.”  Black envisioned a fully automated specialist that made markets, and thereby stabilized prices.  Computerized/algo market making programs based on negative feedback would have bought on today’s decline as Black described.  The rapid snap-back is perfectly consistent with that.

Moral of the story: ignore categorical condemnations of computerized or quantitative trading in the aftermath of today’s events.  There’s good, bad, and ugly.  Be careful, and try to distinguish them.

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  1. When rational thinking men who pride themselves in their ability to make wise decisions let a computer control their financial decision makers, they out to be fired.
    If Wall Street has to rely on dumb stupid computers to make decisions for them, instead of rationally thinking things through like most human beings, then we’d all be better off pulling our money out of the stock market.
    Even palm readers can make more thoughful decisions than a computer.
    And our computers haven’t even achiieved the level of HAL.

    I can’t think of any decisions that needs to be made in my life that I would turn over to a computer to decide.

    Apparently Wall Street has gotten so lazy and incompetent that they no longer feel they can make grown up decisions for themselves and have to rely on computers to do their thinking for them.

    Nothing like what happened today would have happened if brokers would have been making the selling/buying decisions on their own. They would have looked at the situation and decided that there was something wrong with the data that they were being fed.

    Instead they let the computer make a blind decision that resulted in many people loosing a lot of money.

    Wall Street looks more Stupid with each passing day

    Comment by Norris Hall — May 7, 2010 @ 2:08 am

  2. […] Professor Craig Pirrong urges readers to “ignore categorical condemnations of computerized or quantitative trading…  There’s good, bad, and ugly.  Be careful, and try to distinguish them.”  In the […]

    Pingback by Automatic trading and market (in)stability « Knowledge Problem — May 7, 2010 @ 8:22 am

  3. “Nothing like what happened today would have happened if brokers would have been making the selling/buying decisions on their own. They would have looked at the situation and decided that there was something wrong with the data that they were being fed.”

    I laughed hysterically when I read this statement. I remember when I first started trading interest rate futures the Tokyo International Financial Futures Exchange (TIFFE) wanted to start interest rate futures contracts. The built trading pits, brought in floor traders trained them in open outcry trading for weeks on end and finally came the opening day. Some euroyen trader walked into the eurodollar pit by mistake, put yelled out the first bid ever in the history of the exchange (with respect to interest rate contracts) and had no idea euroyen was trading 400bps above the eurodollar contract. He got filled on 200 contracts and the next print was 400bps lower (not out of the range since it was the first trade ever in the contract). There wasn’t “a dumb, stupid computer” making that mistake, it was human error.

    Since that moment, have seen 4 legged options trades put on backwards to the tune of many thousands of cars per leg, I have seen sells as buys more than I care to remember and so many other stupid moves by individuals I could tell stories for days.

    When the sh$t hits the fan on the floor (of any exchange), you just move. You don’t think, you don’t second guess and you don’t “look at the situation and decide that there is something wrong with the data.”

    Computers are tools. When used properly, they are an incredible aid to financial trading. Errors happen. Anyone who has been involved with the financial markets understands this. Its just part of the business.

    Comment by Charles — May 7, 2010 @ 10:08 am

  4. Traders (some) are calling ‘bull’ on the “fat finger” explanation:

    Comment by kacha — May 7, 2010 @ 11:53 am

  5. Norris: computers are programmed to make the decisions people would want to make even if they had no computers. Algo trading follows the same rules as non-algo trading. What do you think traders do in a crashing market? Call Krugman for advice or run into the bullpen with sell order falling out of their fists?

    Comment by kacha — May 7, 2010 @ 11:56 am

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