Fast Trades, Fast Profits… Fast Failure?

photo: artemuestra 

Nearly three months after the now infamous “flash crash” — the trading session that sent the benchmark Dow Jones Industrial Average plunging almost 1,000 points in a matter of minutes — some safeguards are in place to prevent an unpleasant repeat.

Last month, exchange operator NYSE Euronext installed “circuit breakers” on 404 stocks traded on the New York Stock Exchange, which will halt trading if a stock loses more than 10% of its value inside of five minutes. They’ve already been put into use a couple of times in the last several weeks, for reasons that officials still haven’t figured out.

As more trading takes place on electronic exchanges, which facilitate big trades by major Wall Street players, concerns remain over technological advances that could somehow spawn another stock market equivalent of “Terminator: Rise of the Machines.”

A New Trading World

The reason is the prevalence – and profitability of automated trading, a computer-model driven method of trading securities used by pension funds, mutual funds and hedge funds. These models make trades as they get information from automated sources, without the input of a trader’s judgment.

It lets trades happen with very small differences between the bid and offer prices, faster than the human market makers could ever execute transactions. It’s profitable, and it’s big business. Last year, almost three quarters of all U.S. equities trades were so-called “black box” trades.

Because many of these trading models authorize trades on the next best available price, it’s possible they can buy and sell without regard to common sense. In a free-falling market, that next price could be much higher or lower than what a customer really wants. Traders at hedge funds and mutual funds should still be able to use their discretion on buy and sell orders that give clients the best possible “fill” – the point where an order is executed relative to the prices at the time it was placed.

Still a Need for Human Oversight

There’s still little agreement on what caused the May 6 market meltdown, but the experience has a few lessons for small investors, whose fortunes were batted around along with the investments of major Wall Street players.

And trading technology may well have contributed to the chaos. The widespread adoption of high-frequency, algorithmic trading models widely used by hedge funds and large financial institutions didn’t cause the disruption, but the speed with which they went into effect didn’t help matters.

Securities and Exchange Commission Chairwoman Mary Schapiro testified to a Congressional committee that these trading models can be “very effective in providing liquidity in normal trading conditions,” but with a market that’s so accustomed to rapid trade execution, there’s still a need for human oversight.

She also said that so-called held orders — directions to sell or buy a stock at the current market price, no matter what it is — “likely contributed to or potentially exacerbated” the market mess.  

Tom Lydon, president of Global Trends Investments, says the crash was a scary moment, and many investors made it worse with panic selling. While most of the trades made amidst the chaos were nullified, after much effort and frustration, he calls the resulting investigation a much needed wake-up call.

“For the first time in years, it brought out some of the inefficiencies of the market,” he says. “We want to take advantage of technology, and it’s done a great job providing liquidity and ease of trading, but in this finite time period, things broke down.” 

 He says he’s been encouraged by the early effectiveness of the circuit breakers.”By having this system of checks in place, the hope is that markets will avoid this in the future.”