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Wednesday, May 12, 2010

It Seems the Quants Have Struck Again...Still No Explanation for The "Flash Crash"

We are just short of a week since the 8.5% intraday drop in the S+P 500  of May 6. We have yet to hear an explanation from regulators or exchanges As for the market the S+P 500 closed today virtually unchanged from the market open on that chaotic day. So does that mean the whole episode is just something to shrug ones shoulders over and move on.......I hardly think so.

I have no doubt the explanation lies in the complex of computerized,trading, derivative products and leveraged investment fund although I don't know the specific trigger and at this point doubt than anyone ever will..

 I am sure though that the mechanics and drivers (or programmers of the autopilot command) of these hyperactive trading vehicles are at the cockpit of machines that the regulators don't even have the faintest notion of. I am also sure that the folks using these tools don't really know how they will behave when they hit terrain ("market data points") that weren't considered when designing the machines and the autopilot system. 

It seems we have a constant cycle of  people far smarter than I  that get burned by designing leveraged trading strategies based on past data, lose massive sums when the proverbial "black swan hits. There are then the postmortems on how financial engineering "ain't physics" and there are no immutable rules. The quants may be chastened for a brief moment but they return to their engineering bench to build a better trading mousetrap and the cycle begins again.  

In the meantime markets, portfolios, corporations and entire economies suffer the blowback from these adventures in engineering.

Something is terribly broken. I am developing the concept of a "volatility tax" which is being taken out of returns to investors and cost of capital to corporations throught this activity (this is different than an actual tax levied by a govt ). I am not actually sure any entity is even profiting from this tax or whether it is just a "dead weight" cost to the economy. More on that later.

At the end of his book:

The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It     by Scott Patterson

video here interview with Patterson

In which he dissects how the quantitative traders took massive losses on their own books and contributed mightily to the market turmoil of 2008 he describes how they were less chastened than interested in moving onto the newest new thing, The new frontier for these guys was lighting fast high speed trading. Patterson points out in interviews that this was likely a new accident waiting to happen. That certainly seems to be the case


Computer Trading Is Eyed

Debate Turns to Absence of Circuit Breakers, Market Makers as Mystery Plunge Is Probed

Traders parsing the mystery of Thursday's stomach-churning stock-market plunge are focusing on whether rapid-fire computer trading, coupled with the market's complex trading systems, triggered a free fall that appears to have begun with an order to sell a single stock...
Over the past two decades, stock trading has gone from a relatively transparent network of human "market makers" executing buy and sell orders at a handful of exchanges to an almost entirely computer-driven system fragmented among dozens of players. And regulators don't have the ability to directly monitor many of these new players.


The Quants' Computers All Sold At The Same Time

And in what may be the ultimate feedback loop some see the hedge fund connected with black swan guru Naseem Taleeb as responsible at least in part for last week's black swan 900 point drop in the dow.
I have no way to judge the impact of the specific trades but the scenario is  a not uncommon one to varying degrees and certainly played a role in the 1987 stock market crash with the impact of portfolio insurance.

Any time there is extreme price movement in the market those that are short derivative positions that are options or have options like characterstics need to sell (buy) into a declining (rising) market in order to hedge their short positions that are essentially puts (calls), this selling (buying) then can push the market down (up) further triggering more hedging orders and exacerbating the market move.

The phenomenon is well known the author calls it a tsunami of orders, It occurs in "mini" form in markets for various securities and futures particularly at the expiry of options when the underlying is trading very close to a price where there are large holdings of options at the same level (strike price close to market price at option expiry date)


Shortly after 2:15 p.m. Eastern time last Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.
On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.
The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.
Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market. The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.
Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders.
In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.
"Universa alone couldn't have caused the meltdown," said Mark Spitznagel, Universa's founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.

CNBC website today

Black Swan" author Naseem Taleb told CNBC he had no knowledge of a trade that may have caused last week's stock market meltdown even though he advises the hedge fund that is believed to have made it.
According to the Wall Street Journal, a hedge fund named Universa Investments made a $7.5 million options bet last Thursday afternoon that the S&P 500 Index would plunge to 800 by June. Regulators are examining whether that trade may have triggered the mysterious drop of nearly 1,000 points in the Dow Jones Industrial Average .
Taleb said in an intereview that he advises Universa but does not have specific knowledge of the firm's strategy. Taleb rose to prominence with his "Black Swan" book in 2007 that laid out the circumstances leading to the collapse of the financial system.
"I am in general a risk adviser to Universa," he said. "I don't know their positions, I'm not involved in trading."

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