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July 30, 2009

Systemic consequences of exotic trading strategies

It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms. Dynamic portfolio insurance is a way of protecting your portfolio of shares so that if the market falls you can limit your losses to an amount you stipulate in advance. As the market falls, you sell some shares. By the time the market falls by a certain amount, you will have closed all your positions so that you can lose no more money.

It’s a nice idea, and to do it properly requires some knowledge of option theory as developed by the economists Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard. You type into some formula the current stock price, and this tells you how many shares to hold. The market falls and you type the new price into the formula, which tells you how many to sell.

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday. Dynamic portfolio insurance caused the very thing it was designed to protect against.

Many people have been discussing high frequency trading (HFT) over the last few days* and Wilmott's Op-Ed on the subject is one of the many critiques. My gut analysis of this issue, knowing only what I do from readings over the last few days, is that HFT is good, but that the Flash Orders are hideous front running and should be banned as soon as possible. But Wilmott's analogy is misleading, it suggests that eliminating HFT is important because it will protect the rest of us from systemic problems. But that's not the lesson it teaches. Instead it teaches us that those playing with risky and relatively untested strategies in the stock market can end up humiliated and broke.

His argument from analogy above doesn't work for me. When lots of people bought portfolio insurance, they lost a lot of money in October of 1987, and those were realized losses because they had to sell to make use of the insurance. Those who held there stock had recovered those losses within about a year and half. That period requires blaming the full collapse in share prices on portfolio insurance, which is likely unfair given the bullish performance of the stock market earlier that year. It is more likely that program trading compressed the time over which stock prices changes occurred rather than having any influence on their long term value.

*
How big is high-frequency trading?
Judging high-frequency trading
The Matrix, but with money: the world of high-speed trading
High frequency trading as a liquidity tax
High-Frequency Traders Say Speed Works for Everyone
High-Frequency Trading Faces Challenge From Schumer
Follow up on high frequency trading
High-frequency trading
Bloomberg’s Obvious High-Frequency Trading Story

The NYSE is building a special server building to charge higher fees to those interested in high speed trading (NYSE's Fast-Trade Hub Rises Up in New Jersey). I accept that what is good for the exchange need not be good for other market participants. But if it is as some articles indicate that the HFT are half the share volume on the exchanges, maybe they are the customers the markets should be catering to. However, I'm skeptical. HFT may be the average trader on the market, but they are not the marginal ones. If markets become inhospitable to those without high frequency technology, then the HFT guys will drive those slower participants out of the market. If that simply results in a technology arms race where everyone updates to faster and bigger servers and internet pipes, that a wasteful arms race. If it results in greater market liquidity and anonymity, it could be worth it.

Posted by OneEyedMan at July 30, 2009 7:51 AM

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