Near the close on Friday, Anadarko Petroleum (APC) flash crashed. In 45 milliseconds, it went from $90.40 to $0.01. Meanwhile, NYSE has cancelled the trades at or below $87.56, but the question remains. Why did this happen?
At this point, there doesn't seem to be anything indicating a regular "fat finger" error, where a massive order is introduced erroneously into the market and has a tremendous effect. Quite the contrary, the plunge seems to have taken place under the normal functioning of the market.
The probable cause
What would have led someone, something, to sell Anadarko at any price, resulting in this flash crash? I believe the answer is rather simple: hedging activities. In fact, these were close cousins of the hedging activities which brought about the 1987 crash.
Anadarko had a particularity which brought about this hedging activity. It had a massive amount of open interest in May options, both calls and puts. Anadarko had open interest of 108,782 calls maturing on May 17th and 77,711 puts. The overwhelming majority of these calls (87,448) were in-the-money, meaning they had strikes lower than the price APC was trading at going into the close. At the same time, only a sliver of the puts (110) were in the money going into the close.
As the close approached, many of the sellers of those calls would have to deliver stock to the call buyers, and certainly the majority of them were hedged by having bought the stock. At the same time, the sellers of the puts had to do nothing - those puts were about to expire worthless.
Some selling, however, brought APC slightly below $90 going into the close. It is here that the unstoppable dynamic takes place. As APC crosses $90 to the downside, suddenly many of the sellers of $90 calls - a full 25,703 calls, representing 2.57 million shares - out of which at most 15,344 had been closed during the day, were no longer going to have to deliver on those calls. This called - at least for part of them - for the need to get rid of the underlying shares. At the same time, a few puts representing 110,000 shares were now in-the-money requiring shorting to hedge their likely exposure.
As the machines doing the hedging started to push these incredible amounts of stock in a very short period of time, the impact was massive. APC trades an average of 3.4 million shares per day, and now the market was probably trying to sell 1 million shares in milliseconds. So the selling quickly pushed the price lower. And as it got lower, the problem compounded. More and more calls were out-of-the-money requiring no hedging, and more and more puts were in-the-money requiring shorting. In the end, more than a day's volume was probably being attempted to be sold within one second.
The full option open interest and trading volume for Friday follows below (source: Yahoo Finance, but the May options have now matured).
The nature of the market is changing
As Bernanke pushes things farther out into loony land, a couple of events are taking place:
- First, shorts everywhere are being destroyed. Speculative shorts are being taken to the cleaners on any stock where short interest is elevated no matter what the fundamentals are. Even hedged shorts such as in long-short hedge funds are being reduced. And obviously, puts are going out-of-money more and more often requiring less short selling for hedging purposes.
- At the same time, leverage is climbing quickly. Be it through margin debt at historical highs, or through the speculative buying of call options. Anadarko shows how uneven the picture is getting, both with a much larger open interest in calls than in puts, with the calls being much more in the money, and with calls trading nearly 14 times more than puts on Friday.
So basically the short ecosystem is being destroyed and replaced with a market where you are either long or leveraged long. Such a market will find little support if ever there is some kind of downside. Such a market will also be very vulnerable to the kind of dynamics able to produce flash crashes. It's no wonder that these events are now becoming commonplace ever since the Federal Reserve started the printing to support and force markets upwards.
The main implication is that as the market is pushed more and more to one side, these events will become more usual. Sure, circuit breakers being down made it possible as well, but even with those brakes in place it's highly likely that we'll see more of these self-feeding moves in the future. Indeed, as the Federal Reserve removes support, it's likely that a similar market-wide move will take place due to the new market structure where shorts have been banished and leverage has been made the rule.
Two further implications remain:
- First, being levered long in a single stock has acquired the risk of being bankrupted instantly even without negative news, though this is somewhat mitigated by the fact that the NYSE has taken to canceling trades even when not erroneously made.
- Second, it might pay to have distant limit buy orders set up in the markets to buy into quality names at a large discount should some of these flash crashes take place.