Mini-Flash Crashes Continue To Fly Under The Radar
High-frequency trading in the U.S. equity markets continues to result in strange price movements, raising concerns about the interaction of technical glitches, fat finger errors and algorithms in the electronic markets.
Price moves in U.S. stocks that appear to drop or spike upward for no particular reason, only to rebound a few seconds later, have become a daily occurrence in computer-driven equity markets.
[Read: Fallout of the Flash Crash -- One Year On to learn more.]
In the past few months, these events have impacted brand-name stocks, including Berkshire Hathaway, Home Depot, Disney, Amgen and J.M. Smucker.
Some market observers have dubbed these incidents mini-flash crashes -- a name derived from the May 6, 2010, "flash crash," when the market plunged nearly 700 points and then quickly recovered by the same amount in a matter of minutes.
"That's the one thing since the flash crash that we haven't gotten a handle on and it continues to plague us today," says Christopher Nagy (Twitter: @christophernagy), founder of KOR Trading, an Omaha, Neb.-based firm that focuses on market structure and regulatory issues. "It's broad based. From one day to the next, one stock to another, the incidents tend to happen as volatility picks up multiple times a day."
Most of the sudden price moves that occur every day are flying under the radar of the circuit breakers that exchanges implemented following the flash crash. In these instances, Nagy says the stocks may be moving violently, but they're doing so beneath the range that would trigger a trading stoppage.
According to Eric Hunsader (@nanexllc), chief executive of market research firm Nanex LLC, these distortions in price impact both large and small company stocks, and occur on all the exchanges. They can happen for a variety of reasons, including a reaction to news or earnings results, or someone mistakenly using a market order that wasn't intended.
"They just get eaten alive," says Hunsader, whose firm tracks high-frequency trading as it occurs across the 13 stock exchanges and dark pool trading reporting facilities. "Sometimes it's algorithms that are feeding off each based on input prices."
On the heels of Facebook's disastrous IPO in May and Knight Capital's near demise from a software error on Aug. 1, these mini-flash crashes are garnering attention. But exchanges do not publically release data on these events, industry sources say.
Both Nasdaq and the NYSE did not respond to interview requests for this article.
Flash Points: Liquidity Vacuums
Critics of the current market structure blame the mini-flash crashes on high-frequency trading firms withdrawing their liquidity for a short time.
"It is not only a move down or move up. It is a short-term liquidity vacuum," says Sal Arnuk (@ThemisSal), partner at Themis Trading in Chatham, N.J., and co-author of Broken Markets.
Arnuk, whose firm follows these events, often pointing them out on Twitter, says there is typically some type of stress that induces the move. He cites the recent example of Home Depot, whose stock saw a big spike in volume, plunging 80 cents from $63.50, and then returning to that level in less than two seconds. But Arnuk also maintains that high-frequency traders, who are now the primary liquidity providers in the U.S., are the cause of such incidents.
"They are playing a game of trying to maximize their positions to gain a rebate. They want a bid in the stock when they have a very high probability that they will be high in the queue coupled with the same side and the same price," he says.
"Basically, they have a guaranteed profit. It's risk-free and guaranteed economics, guaranteed by the stock exchange. Firms make 33 cents per 100 shares for providing liquidity and then turn it around for 20 cents."
He continues: "Technically, it's trading. HFT shops would like nothing better than a stable Bank of America, KeyCorp and Boeing -- large stocks that they can flip all day long. What happens with the mini-flash crashes is there is a period of stress and that stability becomes uncertainty. Frequently it will be the result of a fat finger error."
Arnuk contends that liquidity vacuums often ensue following a disruption in stability, which can also be the result of a news event hitting the wire. "The ability of these guys to gap a stock and yank liquidity is frightening," he argues.
Traders are also concerned that spikes caused by earnings or company news have become more extreme.
"Stocks have always reacted to news, whether it was earnings or a story like Apple's, like we saw with Pandora's. But the moves seem to be exacerbated by the high-frequency trading," says Peter Lobravico, a seasoned trader who's been in the business for 14 years.
Advanced Trading - ALGORITHMS
High-frequency trading in the U.S. equity markets continues to result in strange price movements, raising concerns about the interaction of technical glitches, fat finger errors and algorithms in the electronic markets.
Price moves in U.S. stocks that appear to drop or spike upward for no particular reason, only to rebound a few seconds later, have become a daily occurrence in computer-driven equity markets.
[Read: Fallout of the Flash Crash -- One Year On to learn more.]
In the past few months, these events have impacted brand-name stocks, including Berkshire Hathaway, Home Depot, Disney, Amgen and J.M. Smucker.
Some market observers have dubbed these incidents mini-flash crashes -- a name derived from the May 6, 2010, "flash crash," when the market plunged nearly 700 points and then quickly recovered by the same amount in a matter of minutes.
"That's the one thing since the flash crash that we haven't gotten a handle on and it continues to plague us today," says Christopher Nagy (Twitter: @christophernagy), president and founder of KOR Trading, an Omaha, Neb.-based firm that focuses on market structure and regulatory issues. "It's broad based. From one day to the next, one stock to another, the incidents tend to happen as volatility picks up multiple times a day."
Most of the sudden price moves that occur every day are flying under the radar of the circuit breakers that exchanges implemented following the flash crash. In these instances, Nagy says the stocks may be moving violently, but they're doing so beneath the range that would trigger a trading stoppage.
According to Eric Hunsader (@nanexllc), chief executive of market research firm Nanex LLC, these distortions in price impact both large and small company stocks, and occur on all the exchanges. They can happen for a variety of reasons, including a reaction to news or earnings results, or someone mistakenly using a market order that wasn't intended.
"They just get eaten alive," says Hunsader, whose firm tracks high-frequency trading as it occurs across the 13 stock exchanges and dark pool trading reporting facilities. "Sometimes it's algorithms that are feeding off each based on input prices."
On the heels of Facebook's disastrous IPO in May and Knight Capital's near demise from a software error on Aug. 1, these mini-flash crashes are garnering attention. But exchanges do not publically release data on these events, industry sources say.
Both Nasdaq and the NYSE did not respond to interview requests for this article.
Flash Points: Liquidity Vacuums
Critics of the current market structure blame the mini-flash crashes on high-frequency trading firms withdrawing their liquidity for a short time.
"It is not only a move down or move up. It is a short-term liquidity vacuum," says Sal Arnuk (@ThemisSal), partner at Themis Trading in Chatham, N.J., and co-author of Broken Markets.
Arnuk, whose firm follows these events, often pointing them out on Twitter, says there is typically some type of stress that induces the move. He cites the recent example of Home Depot, whose stock saw a big spike in volume, plunging 80 cents from $63.50, and then returning to that level in less than two seconds. But Arnuk also maintains that high-frequency traders, who are now the primary liquidity providers in the U.S., are the cause of such incidents.
"They are playing a game of trying to maximize their positions to gain a rebate. They want a bid in the stock when they have a very high probability that they will be high in the queue coupled with the same side and the same price," he says.
"Basically, they have a guaranteed profit. It's risk-free and guaranteed economics, guaranteed by the stock exchange. Firms make 33 cents per 100 shares for providing liquidity and then turn it around for 20 cents."
He continues: "Technically, it's trading. HFT shops would like nothing better than a stable Bank of America, KeyCorp and Boeing -- large stocks that they can flip all day long. What happens with the mini-flash crashes is there is a period of stress and that stability becomes uncertainty. Frequently it will be the result of a fat finger error."
Arnuk contends that liquidity vacuums often ensue following a disruption in stability, which can also be the result of a news event hitting the wire. "The ability of these guys to gap a stock and yank liquidity is frightening," he argues.
Traders are also concerned that spikes caused by earnings or company news have become more extreme.
"Stocks have always reacted to news, whether it was earnings or a story like Apple's, like we saw with Pandora's. But the moves seem to be exacerbated by the high-frequency trading," says Peter Lobravico, a seasoned trader who's been in the business for 14 years.For instance in late September, news broke that Apple would release its own Internet radio service, a move that was widely expected to deal a severe blow to rival services like Pandora and Sirius.
At 3:30 p.m. that day, Pandora's stock dropped from $9.50 to $7.50 based on a hot headline, according to Lobravico, VP of risk arbitrage, trading and sales for Wall Street Access, an institutional broker. The stock then climbed back to $8.50.
Lobravico says he also sees similar moves in after-hours trading.
Algorithms Also Becoming A Worry?
Traders are also worried about algorithms becoming more aggressive.
"Newer, faster, dirtier, nastier algos are coming out every day. I think it's kind of a natural progression," Lobravico says. "The pioneers with the algos that came into the market 10 years ago are much different than the ones they have today."
Algorithms are programmed to execute when certain parameters are met. "A lot of times you're getting an erroneous trade, a fat finger or legitimate news story or something that sparks a rumor in the stock, which triggers another set of parameters," he explains.
For instance, on Oct. 5 a single algorithm was responsible for 4% of U.S. stock-quote traffic, according to Nanex. The program executed at 25 millisecond bursts in 500 stocks after the market's open, and then abruptly stopped working at 10:30 a.m., Nanex says.
Commenting on the incident in a Forbes blog post titled "The Virgin Slut Algorithm," David Leinweber said the algo ate up 10% of the communications capacity for the entire marketplace.
So why the provocative title? The "virgin" part is that the algo "never executed a single trade" and canceled every order, he wrote.
KOR's Nagy attributes such events to the interconnected nature of the markets and the fact that algorithms are listening to each other. "They're all following each other's footprints, time and sales. They're all listening to the futures market," Nagy says. "If a stock is dropping, the algorithm stops liquidity. It's not like you can force these algorithms to participate in the marketplace."
Because of that, this sort of problem is not easily solved, while the list of mini-flash crash incidents continue to grow.
On Oct. 3, an error sent shares of Kraft Foods soaring 29% during the market's opening minutes, although the trades were later canceled. Kraft had recently switched its listing from the New York Stock Exchange to Nasdaq after the company split itself into two units.
Initial reports that day attributed the faulty price spike to a technical glitch or errant algorithm, but Nasdaq later said it was broker error.
Following the 2010 flash crash, exchanges sought to restore investor confidence with circuit breakers by reducing the potential for excessive volatility. They also strengthened the "clearly erroneous trade process" to alleviate the damage that could be caused by fat finger errors. In such instances, a broker-dealer can have errant trades reviewed by the exchange. In turn, the exchange can either break the trade or force the broker stand by it. But what exactly qualifies as an erroneous trade?
If a trader who enters a 5 million-share order intends to use a volume-weighted average price algorithm that executes between 11 a.m. and 4 p.m., but accidentally sends an order that will significantly move the price, the exchange will usually uphold the transaction, according to Wall Street Access' Lobravico.
The only way an exchange will break a trade is if it's a legitimate error, he says. "If a trader types in an erroneous price that is 30% to 40% away from where the stock is, as in the case of Kraft, that print should come down and any related trades that were affected by it will be broken as well," he explains.
But sources say that mini-flash crashes can occur within the bands of the circuit breakers, so they are not always detected. Also, not everyone finds these trading halts to be helpful.
"We have these circuit breakers now. Sometimes you have orders out there and orders are halted and you don't know where you stand," says Lobravico.
"It can take Nasdaq a half an hour to find out what happened, and you get print cancels. You thought you were long or short X. That is a massive liability for broker-dealers who are representing customer orders, because they're out there trading in a market structure that is completely flawed," he says.
In terms of remedies or solutions to curb such episodes, Nagy suggests that the pace of rule-making needs to be slowed down. "We don't understand the unintended consequences of the interconnected marketplace," says Nagy. In particular, he says the pace of exchanges filing for new order types has accelerated, and he contends that it's created a number of mini flash crashes. The rule filings are all "one piece in a larger puzzle of the market structure," he asserts.
The inability of regulators to see all the data has been a hindrance to understanding the causes of the mini-flash crashes as well, according to several sources. "It goes back to the consolidated audit trail," which should give the SEC the ability "to see who is the first mover and who is reacting and interacting with it," Nagy says.
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Advanced Trading
Mini-Flash Crashes Continue To Fly Under The Radar Advanced Trading - ALGORITHMS
