So I wrote this piece earlier
, talking about possible explanations for the carnage yesterday, but not liking any of them. Then I remembered an email I got from a former broker of mine around 2:15pm, talking about the carnage in the BRL-JPY exchange rate. You can look at the yen vs other currencies too, but the bottom line is that the yen spiked before the S&P tanked. What does this mean? Well, the yen is the base currency for the "carry trade." You can borrow Japanese yen, pay their interest rate (basically zero) and invest in other currencies and their markets. You earn the difference in interest rates - the carry.
The email I got was actually a little different from the standard carry trade explanation:
Please see attached chart -- BRLJPY is down 6.2% today and moving quickly, looking at this cross vs SPX you can see it bottomed earlier than equities and have mirrored. This represents probably the single biggest Japanese retail FX position. As I mentiond this morning we saw some very big moves in FX vol and Japan is largely closed this week, this could lead to a much bigger move when Japan comes back next week. Risk assets are becoming highly correlated again.
I think his point was that this indicated a massive de-risking by Japanese customers - selling their higher yielding BRL (Brazillian real) positions, shifting back into their low yielding yen positions.
Now, there are some facts:
- Markets were selling off already before the big crash.
- There is some significant global instability, centered around questions about what will happen in Europe.
Another former colleague of mine writes:
There is a huge problem in Europe with over night Commericial paper market. check out EURBS5 ; the market completely closed and there was no money today.
estimate balance sheet of european banks is 5.5trillion of which 1.5 trillion is funded overnight using commercial paper - sounds like this is the major concern"
In plain English, the fear is that Europe is about to undergo a Lehman-esque scenario where none of the banks are lending to each other. I would expect the ECB and even the US Fed to step in and provide ample liquidity, but in any case, there are some serious tremors effecting global credit and equity markets.
And then comes number 3 - the one that everyone will be talking about: It's almost impossible to argue that algorithms didn't play a role in yesterday's price action. As I wrote earlier, it seemed likely to me that this looked to be a case of Algo's Gone Wild, feeding off each others' signals and resulting in a crazed feedback loop of selling. However, the guys I've talked to so far who are major players in the electronic trading space have told me that they had no issues with their models yesterday - things were normal, and the computers didn't "take over" or "go bezerk" or rack up massive losses. If there are any readers out there running quant models - please let me know your thoughts.
The same big electronic trader suggested that one possible explanation is that an algorithm gets into a "sell loop," where it is sending out a sell order which, for some reason or another doesn't get immediately acknowledged, or doesn't get acknowledged within the threshold for the algorithm. So, the algo, thinking its order didn't make it, spits out another order, which doesn't get acknowledged, and it spits out another, etc etc etc. Why would the algo be coded to send out a new order before it had an "out" on the prior order? I don't know - that seems odd to me, (any algo writers out there? please share your knowledge in the comments section) but I remember a great story that my boss used to tell on our trading desk about how in the old days, when they sent a program trading order to sell a basket of stocks, the old dot-matrix printer behind them would loudly whir to life and print up a confirmation that the basket went. One day, trying to sell a basket, they got no confirmation. Silence. So they hit the button again. And again... and again... Until finally someone shouted - "THE PRINTER IS OUT OF PAPER," as they watched the market fall under the cascade of sell orders that had just been sent.
A third big player in this space just told me "all the HFT guys pulled out of the market instantly," which seems to jive with an article that the WSJ wrote yesterday afternoon
. The high frequency traders don't want this chaos either - it makes it more dangerous for their models to get hooked long or short stock.
While I don't want this to become a debate over the merits of high frequency trading, we need to acknowledge a few things: 1) there is a red herring argument that one of my loyal readers already made in a prior comment thread, to the tune of "but you said that HFT algos would provide all the liquidity we need!" No - what HFT proponents say is that HFT algos provide liquidity, which is always a good thing. I would always prefer liquidity to lack of liquidity. Now people are going to crucify them for NOT providing liquidity! Well, which is it? If you're complaining that you don't like the HFT liquidity, here's what happens when you don't have HFT liquidity! I read comments on other blogs that said things like "I was trying to buy near the lows but HFT algos kept out bidding me by a penny!" Well - wouldn't that be good? Wouldn't that STOP the price decline, if HFT algos kept putting in higher bids?!?!?
On the other hand, 2) there is no doubt that higher speed markets (like we currently have) will have higher speed price movements in boundary scenarios like today. Price movements get exacerbated by speed - but notice that prices recovered quickly too. So, that begs the question - who got hurt yesterday? After all, I asked my dad, "did you see what happened in the market yesterday?" "Yeah - the Dow was down 300 something points." he replied. "Yes - but it was down 1,000 at one point!" I explained. He had no idea - it didn't affect him! It shouldn't affect most people! If you left your trading desk to take a break you might not have known anything crazy had happened when you got back. If you are a normal retail investor who isn't staring at the screen or watching CNBC all day, you probably didn't even know what happened!
The obvious answer of "who got hurt?" is anyone with a stop-loss order. Let's go to Investopedia
for a definition, and a perfect example of what the problem is:
An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit an investor's loss on a security position.
Also known as a "stop order" or "stop-market order".
Setting a stop-loss order for 10% below the price you paid for the stock will limit your loss to 10%. This strategy allows investors to determine their loss limit in advance, preventing emotional decision-making.
It's also a great idea to use a stop order before you leave for holidays or enter a situation in which you will be unable to watch your stocks for an extended period of time.
Ahhh.. But there's a problem, isn't there - and you saw it yesterday. When the stock hits your limit and triggers your stop order, it sends a market order. Obviously, in gapping markets, this can be deadly. For this reason, I'd suggest never using a stop market order - if you really want to have that order in there, use a stop LIMIT order, perhaps with a limit even a decent percentage below your stop price - so that when the order gets triggered, you are trying to execute a sell order with a limit slightly below your trigger price - but not at the market. It all gets back to the fact that I would never use a market order... but let's continue:
NASDAQ has declared
that they will cancel trades where the price varied by more than 60% from the prevailing price at the time (I reported earlier that I'd been told the threshold would be 30%).
Now, I liked the comment
I read on a Clusterstock post yesterday evening that said:
I am waiting for someone to explain why the algos should be entitled to an expectation that the exchanges will cover their butts when their trading programs go nuts
That's a great point. If we're going to allow pervasive algorithmic trading then why do any trades get canceled at all? I THINK that the NASDAQ is canceling these trades in the interest of orderly markets, which certainly is a reasonable goal, but again, it's about bailouts and responsibility. Of course, they also don't want Mom and Pop Retail to have to eat the results of their stop orders gone bad, but in bailing out Mom and Pop Retail, they are also bailing out the electronic algos - if there were any, and it seems likely that there must have been SOME - who sold cheap stocks.
OK - so, in an effort to avoid a lengthy "HFT SUCKS!" - "NO - HFT IS AWESOME" debate, I want to leave you with two quotes from bloggers I read regularly, and which I think are both very valid. First, the "algo's certainly didn't help" point, from one I've been quoting a lot lately, The Reformed Broker, Josh Brown:
The "Fat Finger" thing is nonsense. Maybe someone made a sizable error, but one cannot deny the fact that the algo-driven tradebots poured gasoline on the fire. The machines were triggering stops and wrecking everything in sight before human beings with qualitative senses could get a handle on what was happening.
And then, the "this has happened before, without computers, and it will happen again, with computers" view from TPC
There’s all sorts of speculation over what caused the crash today. The answer is simple. Pure unadulterated fear. Everyone is looking for someone to blame, but we’ve seen this happen in markets for hundreds of years. It happened before there were computers and it now happens that there are computers. Today was a classic fear filled day. We saw huge downside in many debt and forex instruments before the crash and the equity markets were the last to capitulate. The bids fell off the board and the sellers just continued to hit the bids. There might have been some “fat finger” trades or some electronic trading that contributed, but this was primarily fear. Good old fashioned fear. This has always happened in markets and will always happen in markets. It’s as simple as that as far as I’m concerned.
Investors are scared out of their minds as China looks like it is slowing substantially and Greece and the EMU appear to be on the brink. There are real fundamental reasons for the recent declines in stocks. In addition, it’s important to remember that there are a mountain of longs that have piled into the market in recent weeks and months with the expectation of a nice easy recovery trade. That is clearly off the table and there is a huge trade being unwound here. Greed has quickly turned to fear.
The only quibble I have with TPC's comment, again, is that I don't think that fear explains stocks getting hit so hard that they fall to prices of a few pennies. I've never seen nor heard of that before, and I don't think it would have happened if we had old school specialists standing in the middle slowing down every order. That's not to say that I think old, slow, trading is better, however.