×
Home Companies Industry Politics Money Opinion LoungeMultimedia Science Education Sports TechnologyConsumerSpecialsMint on Sunday
×

Lessons for traders from US flash crash

Lessons for traders from US flash crash
Comment E-mail Print Share
First Published: Mon, May 17 2010. 10 28 PM IST

Updated: Mon, May 17 2010. 10 28 PM IST
The exact reasons for the “flash crash” in the US markets on 6 May remain unknown, and so it’s premature to look for solutions to avoid the next such crash. Even so, there have been some suggestions that high-frequency traders exacerbated the fall and that curbs on them are needed.
There’s little doubt that with advancements in technology, reaction times have become faster and, hence, contagion spreads faster. But putting curbs on the use of technology to execute trades faster isn’t the solution. Such falls could happen even with slower trading systems.
Mary Schapiro, chairman of US Securities Exchange Commission, or SEC, said in a testimony for a congressional hearing that one of the factors that contributed to or potentially exacerbated the fall was an influx of market orders. A market order is an order to buy or sell a security at latest available price. If the market moves quickly and if the order book is thin, a market order tends to be executed at a price that’s much higher or lower than what the trader intended. “In addition, the effect of market orders on prices may have been further exacerbated on 6 May by the use of stop-loss market orders. These orders turn into market orders when the stop price of the order is reached,” the testimony added.
Stop-loss orders have been around for years, long before high-frequency traders hit the street. And even though stop-loss orders aren’t generally seen as a form of algorithmic trading, they are. A stop-loss order is an order to buy or sell a security when it reaches a specified price. Stop-loss market orders would have added to the influx of sell market orders hitting the system. The fact that some stocks fell in excess of 60% on 6 May is testimony to the dangers of such an influx of market orders in a falling market.
Of course, market orders and stop-loss market orders would have only contributed to the fall, which seems to have been caused by a confluence of various factors. Apart from the influx of market orders, Schapiro’s testimony points to an absence of professional liquidity providers and disparate exchange practices.
A Barclays Capital note quoted by the Financial News, says that the fall “did not begin and end with trading errors, exchange technology failures or quantitative trading strategies. All of these forces may have contributed to the voracious sell-off, but our analysis suggests that the events on 6 May were more a function of a perfect storm, to borrow a cliché phrase”.
It may take a while before US regulators get to the bottom of what exactly transpired and what measures need to be taken to avoid a repeat. But the flash crash has valuable lessons for traders across the world, including India. Market orders are dangerous in a falling market and should be avoided. Similarly, stop-loss market orders should be avoided. Even with stop-loss orders, traders have the option to prescribe a limit above or below which the trade shouldn’t be executed.
In an opinion piece for The Wall Street Journal, Larry Harris, professor of finance and business economics at University of Southern California’s Marshall School of Business, suggests that SEC should prohibit the use of market orders. “Had the sell orders—including the stop-loss orders—all been limit orders, trading would have stopped without any regulatory intervention when the buy orders were exhausted. Prices would not have fallen to absurd levels,” he argues.
The counter-argument is that the regulator shouldn’t be stopping market participants from selling and getting out at the latest available price. For instance, when the accounting fraud in Satyam Computer Services Ltd was discovered, the company’s share price fell by 77.5% in one trading session. Investors who wanted to get out of the stock at the latest available price would have been constrained by a prohibition on market orders. Harris argues that market orders can be converted by brokers into aggressively priced limit orders. But in the Satyam case, an aggressively priced limit order could have resulted in an unexecuted order, because of the rapid pace at which the shares fell. Of course, the sale would have eventually happened but at a price lower than what a market order would have achieved. Forcing limit orders on market participants doesn’t seem to be a foolproof solution.
Having said that, using limit orders and stop-loss limit orders would save traders millions of dollars. This is an important lesson for traders from the 6 May event and traders using quantitative techniques should programme their orders such that they are released into the system with price limits. This applies not only to high-frequency traders but all forms of traders including proprietary desks.
In The Money runs every other Tuesday. We welcome your comments at inthemoney@livemint.com
Comment E-mail Print Share
First Published: Mon, May 17 2010. 10 28 PM IST