It’s hard to have confidence in broken markets that are easy for big money to manipulate, especially if they’re used for risk management.
That’s why it’s so alarming to see versions of the 2010 “flash crash” recur in markets, as happened recently with a mini-crash in stock markets.
In a series of events better befitting a second rate thriller than a real world occurrence, a devious group calling itself the Syrian Electronic Army hacked into an Associated Press Twitter account April 23 and tweeted that explosions had been heard around the White House and that president Barack Obama was injured.
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Nothing too substantial happened for a few moments, but then the market suddenly melted down: the Dow Jones Industrial Average fell 150 points in a few moments and the Standard and Poors 500 index fell more than a full percent.
Then the White House pointed out that the news item was untrue, and prices shot back to their previous levels.
Welcome to the world of high frequency trading (HFT) and algorithmic trading (the algos), combined with human deviousness.
The new feature here for most is the connection of HFT and the algos with Twitter. Some of the computerized, automatic trading programs, which can trade thousands of futures contracts per second, are now connected to tweets and news organization headlines, firing off buy and sell orders based on analyses of phrases and headlines on Twitter and on websites.
What appears to have happened with the recent flash crash is that a program or a number of programs reacted to discussion of the fake AP tweet and fired off sell orders. Other trend-chasing algos chased the falling market and drove it down quickly, and then other traders backed away from the market, sensing something was up. This caused the automated sell orders to slash prices until buy orders were finally found. Then it all went back the other way after the trend was reversed when the hack was revealed.
With prices back to about where they were before the momentary crash, was anyone hurt? You might think not, but imagine what would have happened to you if you had employed stops loss orders to protect yourself against declining prices.
Traders, brokers and retail investors routinely use stops as a prudent way to ensure that losses can be minimized if prices fall to a certain point. An automatic “sell” is triggered and the position closed. Buy stops can also be used if you’re on the other side of the market.
You might have thought you were protecting a position with a stop, but in reality your position was sold far beneath where it began because of the flash crash and prices then shot back up to where they had previously been. Not only was your hedge lifted, but it was lifted at a loss to prices that day. That happens to people in every flash crash.
It’s a new form of the old phenomenon of “whipsawing,” in which prices move dramatically one way, stops are triggered at loss levels and then the price moves back toward where it began. This happened long before computerized trading programs and was a product of clients having standing orders that traders felt compelled to respect. So in that way, there’s nothing new here.
But what is definitely new is just how dramatically prices can be made to move with no way for most to react. In that context, stops can become a new element of risk in a hedging or investing strategy, introducing exactly the kind of volatility and risk that the hedge was put in place to avoid.
I got a mixed response when I asked traders and brokers whether they still use stops to protect client positions.
One told me that they use them during the day trading sessions, when people are around to monitor that the market hasn’t gone haywire.
However, they always eliminate them before the overnight sessions, when the much lower liquidity means there is a higher chance of them being triggered and the markets manipulated.
Another told me he uses them especially for overnight trading because violent price wrenches are particularly likely to happen then.
Another said he uses stops, but much more carefully and not in the automatic way he would have 10 years ago.
Fortunately for farmers, this flash crash didn’t cause much disruption to crop futures contracts, so it’s doubtful any farmer was busted out of a hedge because of it. The meltdown was limited to a thin collection of contracts and equities and didn’t leak far into the broader markets.
But it certainly draws attention to the incredible influence speculative money, investment funds and HFT have on short term prices in futures markets and a hedger’s ability to use those markets to hedge risk.
Some condemn speculative money in markets, but I don’t. I think the specs add liquidity, which is a good thing. However, the computerized, high frequency trading programs are different.
They are able to swamp a market suddenly, and not as part of any trading strategy other than spotting or creating a trend and chasing and pushing it as far as possible to make a buck. Volatility and instability are their point rather than a side effect.
My last column concluded that aberrations in the Chicago oats futures contract were disturbing for people using them for short-term trading, but were irrelevant to long term prices. As long as people hung on through weird market events such as a cascading selloff that isn’t justified by market or fundamental factors, they ended up doing as well as if nothing odd had happened. In other words, short-term volatility didn’t result in different long-term prices.
But phenomena like flash crashes contain the danger of making short-term aberrations become the long-term reality because if you’re busted out of a position when your stop fires, the depressed price you sold at becomes your price.
Sometime in the future, HFTs and the algos will probably cause such outrageous damage to someone that regulatory controls will be imposed to prevent them abusing and contorting markets.
However, until that happens, farmers not only have to worry about risk from the weather and from market fluctuations but also whether their carefully hedged position has become a new and dangerous form of risk, rather than a way to avoid it.
