Streetwise Professor

May 7, 2010


Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 12:09 pm

NASDAQ has decided to cancel–bust–trades made between 2:40 and 3:00 PM ET if they were at prices more than 60 percent away from the market price prior to 2:40.

Very bad idea.

The orders executed at these prices were almost certainly stop orders.  Old fashioned stop orders.  The kind that have been destabilizing for years, not some newfangled HFT thing.  When stops are hit, they reinforce the price movement that triggered them.

Busting these trades therefore encourages the use of a particularly destabilizing type of order.  If the idea is to reduce the amount of positive feedback in the system, this will have the exact opposite effect.

There is still no definitive understanding of what triggered the selloff.  The P&G story seems bogus–the slide started before that.  Yes, algorithmic trading or program trading of some sort was probably involved.  Let’s try to think of the most likely trigger.

A big index futures sale that really moved the futures price would have triggered sell orders in stocks generally, first in the index component stocks, then in other stocks (as correlation or pair algorithms kicked in). The main effect of algorithms would have been to speed the transmission of the initial shock.  The question is: what would have caused a big index futures trade?  An error?  (CME says its system worked fine, and Citi denies it was involved in any erroneous trade, as had been rumored.)

There are no answers right now, but the methodology for providing the answers should be pretty straightforward, and ironically, the very accurate time sequencing and record keeping made possible by electronic trading will greatly ease the process of implementing that methodology.   Look which markets moved first.  Look at the orders that were associated with those moves.  Then trace the effects from there.  Knowing where the event started, the basics of algo trading strategies makes it straightforward to hypothesize how the shock wave should have traveled.  One can then test those hypotheses to see whether in fact these strategies accelerated the decline.

There are also reports that many HFT traders withdrew from the market when things got crazy.  This isn’t surprising, really.  That’s what market makers do.  (Remember the stories of NASDAQ market makers not answering their phones–or making markets–during the ’87 Crash.  Or clearing firms yanking their locals off the floor on that day.)  This is very consistent with the Greenwald-Stein story of how a big volume shock can lead to higher execution risk which causes a decline in liquidity which in turn makes the market more volatile.  That is another feature inherent in continuous markets, human or automated.  HFT firms that make markets won’t behave that differently than human market makers.  They’ve just embodied the logic in the market makers’ heads into computer code.

Another thing that is consistent with the Greenwald-Stein story is the report that the NYSE liquidity circuit breakers exacerbated problems.  Greenwald-Stein recommended that in the event of a major disruption, the market transition from continuous trading to an auction market.  That’s what NYSE did.  But this apparently resulted in orders being redirected to other execution venues.  The circuit breaker deprived the market of NYSE liquidity for a time, and the wave of orders stressed liquidity in other venues.  But one of the points that was made clear in the aftermath of the ’87 Crash is that circuit breakers have to be coordinated.  Tripping a circuit breaker in one market but not the other can make things worse, not better.

One thing that is not really consistent with G-S is the rapid rise in prices after the plummeting fall.  Indeed, the rise is in some ways more remarkable than the fall.  It is almost vertical, with the Dow moving up more than 4 percent in less than 15 minutes, with most of that distance covered in about 10.  This suggests that value buyers jumped on the opportunity, and drove up prices.  In G-S, the execution risk keeps the value buyers away.

Thus, another important question is: who were these value buyers?  Mightn’t they have been algo/HFT traders?  If so, it is imperative than any rule changes or regulations implemented in response to this event do not cripple those using negative feedback strategies.

I am probably asking for too much there, as the tendency to lump traders into big categories is very strong, and the ability and willingness to make careful distinctions virtually absent.

And it is highly likely that stop order traders who almost certainly exacerbated the price decline will not receive proper scrutiny, and indeed are likely to be pitied as victims; busting trades is consistent with that narrative.  That would be a real pity, and would betray a failure to understand what kinds of orders and trading strategies are destabilizing.  Stop orders should be taxed, if anything, and those using them don’t deserve pity–or mulligans.

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  1. Excuse me? Stop orders have now become the new cigarettes, evil things we should tax? Yeah, that makes sense: so people who have a pretty clear idea how much pain they are willing to take (or how much risk) shall be punished. Going on vacation while holding stock? Fahgeddaboudid – you better cling to your damn trading terminal all day, night, and every day, because otherwise we, the Great Protectors of the Market will kick you in your lazy buttocks. Public Good Rules – never mind how much that sucks for you as an individual.

    Professor, I really thought better of you.

    Comment by kacha — May 7, 2010 @ 1:06 pm

  2. To follow up: your opposition to stop-orders is a bit like, if not almost the same as, the obsession that some people have with short-selling. Look, you can’t short a solid stock, and you can’t stop-order-self-reinforce-to-hell a solid stock. What if a stock really tanks by itself because it’s lousy, and the market ‘decided’ to let it go the way of Bre’X – what harm to stop-orders do? I’m sure there were stop-orders on Bre’X and Enron as well, and boy did they kick in when the shit hit the fan. You really suggest those people who managed to get out in time should be punished?
    Seriously, you really make me angry today – and

    Comment by kacha — May 7, 2010 @ 1:10 pm

  3. Stop orders have uses yes, but they also have destabilizing potential. This is hardly news. Relieving those who use these orders of the costs of doing so, particularly when these costs are incurred precisely when these orders have negative external effects is a very bad idea. You want people to internalize the costs and the benefits. Busting trades means that they do not bear the costs. Bad thing. Even when you don’t bust trades, the pernicious effects of stop orders are not fully borne by those who use them.

    The suggestion of a tax was intended to be provocative, and it apparently had that effect on you. But the economics are quite basic. I mainly want to point out that in the hysteria over algo trading and HFT, it is quite likely that a very traditional sort of order is far more culpable, and deserves closer attention.

    There is a clear difference between a stop and a short sale. You’re the one confusing them, not me.

    The ProfessorComment by The Professor — May 7, 2010 @ 1:34 pm

  4. I guess our difference here is philosophical, not analytical (and yes, short orders are different – merely pointing out that some people are getting their knickers in a knot over them as well, using similar language). I don’t buy the ‘externality’ argument here, because my definition of externality is very, very narrow, limit to physical damage of property/body. Your stock tanking in price because of somebody else doing something with their property is not an externality to me, it’s just what happens. After all, we don’t compensate people for losing money on their hoarded water during a drought when somebody comes in delivers water for free/starts a rain. You don’t have a property claim to the value of your stock, you only have a property claim to your stock. If stop-orders meant I TAKE your stock away, that would be a different story. If a stop order means your stock loses value, that’s tough luck.

    Your failure to plan is not my problem.

    (use of 1st and 2nd person for stylistic purposes only)

    Comment by kacha — May 7, 2010 @ 2:05 pm

  5. The rapid up move doesn’t in itself suggest value buyers jumped at the opportunity. It could have been an abatement of selling. No doubt an element of both

    Comment by LB — May 7, 2010 @ 2:54 pm

  6. Interesting post.

    As you point out, theoretically it should be interesting to pinpoint the locus of the chaos.

    However, practically it may be a different story. I find it interesting that no official report has yet been released.

    I look forward to seeing the official report. One would think that if the selling avalanche was truly caused by a random error, that the stock market would have been up sharply today. Instead, it was down.

    It is interesting to ponder how such a bizarre occurrence can occur in purportedly highly liquid (and some believe “efficient”) markets…

    Comment by Ted Kavadas — May 7, 2010 @ 4:45 pm

  7. Stop orders, if there are too many of them on the downside, can cause a market crash in a matter of days.
    Imagine for a minute that MOST investors instructed their brokers to place a stop-loss order on each of their stock holdings. Here is what will happen. As the stock price – let’s make it IBM – declined from $100 to $95, a number of stop orders were executed, and price declined to $94. As the price hit $94, another bunch of stop orders were executed, and the price hit $93. And so on. IBM can lose, in theory, 50% of it’s value in a matter of a few minutes.
    If I were one of the Wall Street crooks and criminals, I’d look where the stop orders are, and I’d raid them. As they do from time to time. Electronic trading makes it easy for them to see where the victims are.
    It’s like shooting the fish in the barrel.
    There is only one way to protect the investors. On the 1st day of every month every large Wall Street firm must declare all holdings in its investments. Stocks, options, futures, – everything. Long positions, short positions, on balance, off balance, up, down, sideways – everything. Then we will be able to see what the crooks are really doing.
    Why the mini-crash happened? Market makers stopped supporting the market. Obviously. Otherwise, the initial drop would not take place. Stop orders were executed in rapid succession, which caused market decline. Short sellers arrived and started to short the market. At that time market makers started to buy from short sellers, and then buy at higher prices. Guess what? Short sellers place stop-loss orders too. Market makers raided those stops, and the market recovered.
    Looks like short sellers were punished in order to scare them away, if only for a short while. I bet a dollar that a real decline is coming while short sellers are licking their wounds.
    To understand the stock market, one should study criminal psychology: how would criminals behave in this situation? The stock market is one of the few places where fools are separated from their money lawfully.

    Comment by Michael Vilkin — May 8, 2010 @ 8:42 am

  8. Again, maybe fools should be separated from their money – provided it happens without violence or fraud. Nothing you describe is fraud or violence. Too many fools in the market. But – they wouldn’t be there if they weren’t forced thanks to bank created inflation (central bank printing and fractional reserve fraud).

    Comment by Kacha — May 8, 2010 @ 5:18 pm

  9. Kacha wrote:
    “…bank created inflation (central bank printing and fractional reserve fraud).

    Kacha, what are you talking about?

    First, “central bank printing” does not increase inflation simply because newly printed paper currency does not increase M2.
    Get a textbook and look it up.

    Second, “fractional reserve fraud” is not at the root of problems.
    We can print tons of new paper and make it mandatory for banks to have 100% reserve requirements.
    Only one positive thing will come out of this: banks will not be afraid of run on the banks, and they will continue to support economy through lending. OK, granted: this by itself would be very positive for the economy.
    My guess is that the financial mafia needs to create economic downturns from time to time in order to buy assets at low prices. That is why 100% reserve requirement is out of question. Unless, of course, you replace that bum in the Oral Office, O’Bum.

    Comment by Michael Vilkin — May 8, 2010 @ 10:59 pm

  10. Michael, I don’t have the time or inclination to educate you on monetary theory. If you are interested in learning about economics, including monetary theory, you may want to start to stretch your comfort zone by reading some Friedman, and when you feel your mental muscles itching for some real workout take a deep breath and dive into the intellectual universe of von Mises.
    Alternatively, you can continue to bore me with bizarre statements about what does or does not influence different monetary measures. Ciao.

    Comment by Kacha — May 9, 2010 @ 7:04 am

  11. Kacha wrote:

    “…bank created inflation (central bank printing and fractional reserve fraud).

    Kacha, “central bank printing” does not increase inflation simply because newly printed paper currency does not increase M2.
    Get a textbook and look it up.

    Comment by Michael Vilkin — May 9, 2010 @ 4:38 pm

  12. Ah, but Michael: what happens when your newly printed paper currency leaves the print shop and enters the economy? What then, Michael?

    Comment by Kacha — May 9, 2010 @ 5:00 pm

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