Newest Addition to the Team, Taste_Arbitrage: Flash Crash

14 May

I have tried my best to keep my frustrations to myself over the course of the past week but it has simply become too much. Before the super terrific congressional blue ribbon panel starts to impose all sorts of rules on the trading of securities, I thought it would be helpful if I cleared some things up about the “flash crash” and the number of things people are blaming it on.

The straw that broke the camel’s back as far as my patience was concerned is this nugget from an anonymous NYSE floor trader I have a host of problems with this drivel. First and foremost, to those of you who have never ventured onto the NYSE floor and my have some delusions of grandeur from seeing CEO’s ring opening bells or old videos of traders singing ‘Wait till the sun shines, Nellie’, I am sorry to ruin your fantasy but it is a goddamn graveyard down there. I went on a prep school field trip and was simply amazed by how many people continue to grasp at it like it is a viable way to make a living, and that was ten years ago. I was also on the Boston Stock Exchange a few weeks before they closed down and it is clear that is not the way to trade. To paraphrase Danny Devito’s speech from ‘Other People’s Money’ I am sure this guy makes the best goddamn buggy whip you ever saw, but this business is dead.’ There should be zero floor traders anywhere. Next up, there was by no means a “wiping out $1 trillion in wealth” in a matter of minutes. Fluctuations in price do not wipe anything out, especially when they rebound almost instaneously. If that is going to be a point of contention then there should never be any selling of securities ever. Markets are not established to go up ad infinitum, they are to exchange securities at prices that counterparties see fit. David Weidner, resident asshat at the WSJ, felt the need to reprint people blaming it on the shadow banking system. Since clearly he and whomever raised that point have no idea what that means I highly recommend they read Paul McCulley’s latest GCB piece out of PIMCO. He invented the term and it has absolutely nothing to do with brokerages pricing equities. Please, do some level of homework before you start spewing of conspiracy theories about market structure.

I could try to explain to you what did happen and contrary to what you may be reading today it was not all because of some mystery trader at Waddell & Reed. However a far better run down of the entire thing has already been covered. Barry Ritholtz posted the play by play from another young institutional analyst. Although we differ on the true problem here, he gives a very clear view of how things transpired last Thursday. “So what happened here? Three things:

1. Sellers probably had orders in algorithms – percentage-of-volume strategies most likely, maybe VWAP – and could not cancel, could not “get an out.” These sellers could be really “quanty” types, or high freqs, or they could be vanilla buy side accounts. It really doesn’t matter. The issue here is that the trader did not anticipate such a sharp price move and did not put a limit on the order. The fact that the technology may have failed does not mean the
trader deserves a do-over, it means that the trader and the broker who provided the algorithm need to decide whether any losses should be split.

2. Sell stop orders were triggered which forced market sell orders into an already well offered market.

3. While the market was well offered, it was not well bid. Liquidity disappeared. For example, in P&G, 200 shares traded at $44.10 at 2:51:04 in the afternoon and one second later, at 2:51:05, three hundred shares traded at $47.08. That’s a three dollar jump in one second. Bids disappeared, spreads blew out, and no one was trading except a handful of orphaned algo orders, stop sell orders, and maybe a few opportunists who had loaded up the order book with low ball bids (“just in case”). High frequency accounts and electronic market makers were, by all accounts, nowhere to be found.”

for his entire piece (which I advise any and all to read) here it is at Barry’s blog

I keep hearing how terrible this event was, and if nothing is changed it could happen again. Oh no, what ever shall we do?! Here’s a thought, if you think the price of a security is too low and you think it’s insane that it doesn’t seem to have a bid, you should just go ahead and bid. That’s it. If the price is too low, pay it and make money. Only one group of people on earth that should be upset about what happened last week are PM’s like Tony Welch that the WSJ looked at earlier this week They are guys who saw what they thought to be a price irregularity and pounced on it, only to get their trade cancelled for no reason whatsoever by people making up rules ex post facto. Especially when another PM that sits within spitting distance of his desk gets his fill cleared because he was a minute later and didn’t get as good of a price. I know a lot of people are under the impression that “regular investors” could be hurt by drastic market moves like this, but since the overwhelming majority of that buy side money is with large institutions guess what, they are all trading electronically with algos too, because it is the best way to do things. It’s faster, it’s cheaper, and most of all it helps these bohemouths keep from showing their side and getting front run all day. If somebody decides to put market orders out there they need to understand what they are doing and live with the consequences of that. It only hinders markets to do things like implement circuit breakers or time stops to let people that are too slow to catch up and adjust accordingly. It could easily lead to the sort of problems that are often seen in commodity markets where nothing trades for days or weeks on end because these measures get triggered immediately and the markets force zero liquidity on the day in the name of orderly price movement. Prices do not and should not move in any orderly fashion, they should move however the fuck they see fit.

What happened last week was simply markets correctly repricing risk during a day which had a whole host of unfavorable variables. In doubt? I recommend you take a look at LIBOR-OIS over the past two weeks.Risk was simply becoming more expensive. If you don’t want to be a part of that don’t trade on electronic exchanges. It had no ill effects on long term investors. It may have hurt the PnL on a few intraday traders but I must reiterate that is the only way exchanges work. They are prone to drastic swings when new information enters and that is a good thing. If anyone believes they have a better idea of how something should be priced they should simply participate and make money off of their knowledge.

That said, happy hunting out there.



12 Responses to “Newest Addition to the Team, Taste_Arbitrage: Flash Crash”

  1. pcdunham May 14, 2010 at 5:22 pm #

    Good stuff. Glad there are others out there that arent drinking the “blame computers” koolaid. I think the issue was in the short term funding LIBOR/EURIBOR markets brought on by the EuroZone crisis. Hence the monster Yen move against USD & EUR. Check out an intraday chart of e-mini S&P’s, USD/JPY and P&G. The USD/JPY was leading S&P’s and was almost finished its move befoe P&G started to sell off. Prof_Pinch had a few good posts on the subject & I wrote something as well.

  2. Byrne May 14, 2010 at 5:27 pm #

    Circuit breakers are practically designed to fatten the tails. If a 20% decline shuts the market down for the day, then anyone with liquidity worries will treat a 19% loss as a forced stop-loss point. And if 19% is the universal stop-loss point, you have an incentive to sell at 18%, or 17%, etc.

    The funny thing is that this could create a ton of short covering at, say, a 19.9% drop, on the assumption that the market will open higher.

  3. jckh May 14, 2010 at 6:05 pm #

    It’s a religion among the media that “high prices are good, low prices are bad.”

    It’s neutral. And any particular trade is zero-sum. Your average WSJ reporter is, frankly, a half-wit that exists to be played by flaks.

    • Anal_yst May 14, 2010 at 6:09 pm #

      Heresy! The average financial journalist comment is pretty spot-on from where I sit, but the good ones (who more often than not actually worked or studied business) unfortunately get a bit of the bad rap. However, like you said, most need to get the f*ck out of the business and stop trying to dumb-down things they don’t understand for Joe & Jane 6-Pack, especially when they’re so piss-poor at it.

  4. Morgan_03 May 14, 2010 at 9:27 pm #

    well done.

  5. Kid Dynamite May 14, 2010 at 10:15 pm #

    you forgot to blame the dark pools. i read it in the NY Times that the dark pools cause a lot of problems (NOTE: SARCASM!!!!!!!)

    ps – paragraph breaks please!

  6. Kid Dynamite May 14, 2010 at 10:20 pm #

    also – what say ye to those who say that poor retail investors with stop loss orders got plugged?

    in my mind, this whole event needs to be used as the educational point, so that there are never any more excuses in the future. Make sure people are aware, so they can’t play the “I didn’t understand that could happen” card.

    I’m amazed that retail brokers aren’t reacting – putting restrictions on stop orders (so that they only accept stop LIMIT orders) and making sure that clients know exactly what they are doing. I need certification to sell a call option, but not to enter a stop order that in most scenarios is likely to totally hose me ???

    i’m going to continue my crusade that the simple solution is just to ban market orders. do that, and no one can ever get filled at a price they don’t understand… voila.

  7. taste_arbitrage May 15, 2010 at 1:18 pm #

    Thanks for giving this a look. First off sorry about paragraph breaks as this is my first time writing anything I am still working out plenty of kinks. My editor being on our equity research desk helped w/ a few things but clearly neither of us were english majors.

    On to the real things. I can’t believe I forgot to mention dark pools. They sound so sinister they must be trouble! I heard some kid drowned in Credit Suisse – CrossFinder at a birthday party last summer. True Story.

    I could not agree with you more that this event should be looked at as educational point. Although I don’t give any credence to the “I didn’t understand” crowd, everyone would be better served by knowing how their orders can stand to be executed.

    I wouldn’t go as far as banning market orders simply because I am of the thought process that I alway prefer more tools too less. I would be much happier if people were simply emailed a pdf copy of the series 7 (or other relevant licensing exam of your country) study materials, so that they can get a handle on how orders work. Education is important, but if you get a stop loss triggered somewhere that you could not have imagined beforehand there is no way to more effectively gain that education. Traders make mistakes be them retail or institutional but you move forward and learn from them. Markets aren’t here to apologize for people’s mistakes and to give them a ‘do over’. My hopes are simply that people learn that markets can react at speeds that at the time seem unfathomable. This is not a new concept it is just one that needs to be reinforced from time to time as people get too comfortable for their own good.

    Thanks again everyone for reading this. If you want to toss some more thoughts my way feel free to contact me at taste (dot) arbitrage (at) gmail (dot) com

    • Kid Dynamite May 15, 2010 at 7:32 pm #

      so, yeah, i’m in favor of less restrictions too, but instead of bailing people out, i’m in favor of some draconian measures to protect them from themselves while at the same time – and here’s the important part – removing excuses… mortgages, for example: i think you should need a license to get a mortgage – a simple piece of paper that shows that you understand the payments, especially if you have a non-traditional mortgage. then, if things go wrong, you can’t turn around and blame your bank, society, Wal Mart, John Paulson, Hank Paulson, Goldman Sachs, or the tooth fairy – it’s YOUR responsibility.

      same thing with trading: if we remove market orders, then every order, by definition, has a limit price entered by the trader, and there are no longer any excuses possible.


  8. Royal Arse May 21, 2010 at 8:01 pm #

    Great work — I’ve been digging as deep as possible into the probable causes of this crash and can’t get enough.

    Excellent subsequent discussion as well, Kid Dynamie’s been a great source of info on this as well. Thanks for the insight.

  9. forex trading August 1, 2010 at 7:09 am #

    Hiya what entice you to definitely location an write-up? This document was very intriguing, especially since I used to be researching for thoughts on this topic final Thursday.


  1. Sunday links: electronic incivility Abnormal Returns - May 16, 2010

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