Joseph Saluzzi (jsaluzzi@ThemisTrading.com) and Sal L. Arnuk (sarnuk@ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

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Some Thoughts:

15 Stocks fell more than 50% from high to low.

61 Stocks fell more than 20% from high to low.

Exchanges solution: Bust Trades > 60%



In my personal portfolio I own Phillip Morris (PA) and Boston Beer (SAM), makers of Marlboro smokes and Sam Adams beer. I was feelin’ allright when I stepped outside to grab a smoke and a brew (I do my best trading after a few  Sam Lights and a few Marlboro Reds). OK. I really didn’t do that. And I don’t really own those two stocks either. But if I did, then yesterday afternoon I would have smoked a pack and drank a case.

Phillip Morris High/Low/Last = $48.92/ $16.74/ $46.75

Boston Beer Co Inc. High/Low/Last = $63.17/ $00.01/ $55.43

Today’s action left us amazed, and we have been warning about this stuff since December 2008. Where do we even start? Yesterday afternoon and evening all the business programming focused on how the markets were in turmoil, and Greece this, and overdue correction that, and fat finger the other thing. They couldn’t even recognize the story, as even the business media doesn’t understand that the markets are a changed structure and beast. The story is not a key-punch error. The story is a failed market structure. The market failed today.

The market melted down and “liquidity providers” quickly pulled all bids. According to today’s Wall Street Journal, high frequency firm, Tradebot, closed down its computer systems completely, as did New Jersey’s own Tradeworx, who was so critical of our silly market structure comments in their SEC comment letter. By the way, if you don’t know who or what Tradebot is, it is the proprietary trading engine that used to be part of the BATS exchange. In fact the reason BATS was rolled out as an exchange to begin with was to lower costs and facilitate trades for Tradebot (Tradebot’s 1251 NW Briarcliff Pkwy Kansas City address is next door to BATS’s North Mulberry Drive address fyi). In the WSJ article Mr. Cummings said his Tradebot system was designed to stop trading when the market becomes too volatile, because he “doesn’t want to compound the problem.” Too bad he doesn’t understand that that was and is the problem. To make matters worse, while some high frequency firms shut down yesterday and pulled their bids, as we warned they would do for over a year and a half, other high frequency firms turned from being liquidity providers to liquidity demanders, as they turned around and indiscriminately hit bids like Randolph and Mortimer Duke.

We are just plain outraged, and think every investor and market participant in the USA should share this outrage. They were sold a lie. How many times over the last year have we all heard that HFT liquidity was a blessing that lowered costs and helped investors, and that it would be there in stressful markets just like the market makers and specialists they replaced were there? How many times have you read in the big media that HFT helped the markets perform brilliantly during the global meltdown in 2008 and 2009? We said it before and we say it now. Lies.

Not so long ago, if our markets experienced severe stress, and certainly a “fat finger”, human wisdom would intervene. Reasons for the stress would be ascertained, trading in affected stocks would be slowed or halted, stabilizing bids would be initiated as needed, and severe volatility would be dealt with in a calm and reasoned manner. Today, the human specialist model has been replaced by an automated market maker model. Our market structure has evolved. It has evolved, not by design,
or a well-thought and reasoned plan, but it has evolved to cater to masters of expensive technology, deployed unfettered by participants whose only concern is to squeeze out every last picosecond and fractional cent before they move on to other countries’ markets and asset classes. The for-profit exchange model at every chance sacrifices the protection of long term investor interests for the profitability of serving hyper-leveraged intraday speculators. By the way FLASH orders are still utilized at Direct Edge, but that is here nor there.

Today’s price swings in a great number of stocks highlight the inherent and systemic risk of our automated stock market, which has few checks and balances in place.  Once the market sensed stress, the bids were cancelled and market sell orders chased prices down to the lowest possible point. Investors who thought they were protecting themselves with the prudent use of stop orders were left with fills that were far away from the closing price. In some stocks like our SAM example above, this was $0.01. We warned of the potential for HFT to behave this way when we met with and showed our regulators the NY Fed study that highlighted HFT’s vanishing act around stressful news announcements in the currency markets.

We read this in a recent comment letter to the SEC about HFT and couldn’t agree more: “When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence.”

The EXCHANGES’s response late yesterday was to cancel trades that moved by more than 60%. Yes 60%. SO if you bought a stock at $21, put in a stop-loss market order at $20 (expecting to get filled in a market decline of somewhere less than but close to $20), and got filled at $10 (yes this happened and worse), your trade stands! And if you bought this same company’s stock (that fell from $20 to $3 before closing back at $18) at $3 and sold it at $14 thinking you made a big profit, your buy is cancelled, you are short stock at $14, you have a loss, and the futures are green this morning. Inspires investor confidence, right? With this wise remedy and redress by our exchanges, along with their other maneuvers (stay tuned for our coming Data Feed White Paper), one can’t help but be confident in playing ball on this level playing field. NOT.

Today’s severe market drop should never have happened.  The US equity market had at been hailed as the best, most liquid market in the world. 
The market action of May 6th has demonstrated that our equity market has major systemic risks built into it.  There was a time today when folks didn’t know the true price and value of a stock. The price discovery process ceased to exist. High frequency firms have always insisted that their mini-scalping activities stabilized markets and provided liquidity, and on May 6th they just shut down. They pulled the plug, as we always said they would, and they even admit it in the papers this morning. We need a new mousetrap. This is not an isolated incident, and it will happen again.

Where we left off 4:00pm EST:

INDU                      10520.32                               -347.80

SPX                        1128.15                                 -37.75

CCMP                    2319.64                                 -82.65

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See also:
Why Institutional Investors Should Be Concerned About HFT
Themis Trading, 09 Jul, 2009

http://blog.themistrading.com/?p=171

Category: Data Analysis, Employment, Markets, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

5 Responses to “The Emperor Has No Clothes; We Need A New Mousetrap”

  1. X on the MTA says:

    This is why I use spreads or collars instead of stops whenever possible or STOP/LIMITs. it’s also nice that in the case of sudden drops the volatility skew works with you

  2. chomen says:

    It’ll happen again soon. It’ll be much more vicious. “Bail out! Bail out! Bail out!” No one woke up this time around. Next time, they will.

  3. Purewater says:

    BR, Not being a smart ass here…have you reconsidered your stop-loss recommendation?

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    BR: Do not confuse risk management and having a stop discipline with entering stop loss orders. with the silly approach of putting in Stop loss orders.

    I NEVER advocate putting stop losses into the system where they can be picked off.

    There is an enormous difference between a capital preservation discipline, and playing poker with an open hand. Stop loss orders are a suckers game.

  4. alfred e says:

    @BR: I think you just tipped your hand.

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