The first article of mine that was picked up by the Sandusky Register was written in the late afternoon on May 6th, 2010 as I put together the notes for our clients explaining the “Flash Crash,” what and how it had happened. Tuesday afternoon the Twitter account of the Associated Press was hacked and the following tweet was sent from their account, “Breaking: Two Explosions in the White House and Barack Obama is injured.” The stock market plunged one percent in less than three minutes. Within five minutes, it had returned to its previous level. Let’s take a look at some of the issues this brings to the trading table.
The market is always the boss. Traders at their desks can employ a thousand models suggesting the market should move in a certain direction. However, anyone sitting at a trading desk or on the trading floors will tell you, when you’re in the market, you’re playing the market’s game on the market’s terms. Therefore, when prices move rapidly and unexpectedly against a trader’s position self-preservation kicks in and the trader exits the position – THEN searches for the catalyst that suddenly turned the market against them. Rule number one in trading is self-preservation.
This mentality is best evidenced by protective stop loss orders that automatically trigger when a market moves beyond the trader’s loss threshold. Meanwhile, another group of traders prefers to exercise their own orders in which case, they’ll manually enter their order as the market exceeds their pain tolerance. These two groups were the ones hit with losses as they raced each other to the bottom in an attempt to unload their positions. For the record, our protective sell stops were also hit on the way down. Think of it as a bank run. There’s always enough cash to cover the withdrawals of those at the front of the line.
The traders most deeply affected by the sudden downdraft and ensuing return to normalcy were the day traders and the high frequency traders. Our position in the Russell 2000 stock index yesterday was a day trade on the long side of the market based on follow through from Monday’s outside day. Monday’s outside day is defined by falling through Friday’s low only to turn around and close above Friday’s high. This is a very bullish signal when coming at the extreme of a recent move. This outside bar combined with some other analysis put us on the long side. Protective stops had been placed and adjusted throughout the trade leading to a small win. In this case, not placing a protective stop would’ve been much more profitable but, what if the Associated Press had been right?
Once the market began to sell off, high frequency traders joined in the game. High frequency trading is day trading without the human input. Humans write the computer programs and the programs being fed the live data stream automatically executes the trades at the exchange. These programs have replaced the scalpers you’re used to seeing on TV in the trading pits yelling at each other. High frequency trading gets a bad rap for increasing market volatility but gets no credit for providing market liquidity. Liquidity is THE most important aspect of U.S. financial markets. Liquidity is why we are the global financial capital. Without liquidity there is no one to take the other side of the trade. Without liquidity there is no market.
Finally, let’s put it all together. The market was quietly trading up about half a percent on light volume when the AP’s tweet was posted. Volume exploded by a factor of 10 as the market declined. The volume surge that was taking day traders and tightly placed protective stops out of the market was being replaced by high frequency trading programs that are ALWAYS called to action by volatility and volume. Ironically, the same high frequency trades that made a killing during the flash crash actually got burnt by the, “Hack Crash” as the market returned to normal faster than newly initiated short positions could be covered at a profit.
There is little predictive value in the events of the, “Hack Crash.” However, there are some key takeaways for traders. First is the importance of protective stops. One never knows what could happen next. Second, verify news reports. I have the AP’s iPhone app, which alerts me to breaking news and had no mention of the tweet until after the fact. Therefore, the corporate disconnect between Twitter and their app was my first clue it was bogus. Finally, cut the high frequency traders some slack. Their programs are based on risk and reward just like our own and the liquidity they provide in times of dramatic events is exactly what allows us to get out of the market and keep some powder dry until the smoke clears.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.