The dangers of Quant Trading models; Dow’s 1000 point drop a
prime example
May 7, 2010
Build a system that even a fool can use, and only a fool
will want to use it.
George Bernard Shaw, 1856-1950, Irish-born British Dramatist
The initial trigger for drop in the Dow was probably due to
fears that the Greek crisis was going to spread. One could
credit this for 300 or maybe even a 400 point drop in the
Dow; however, a 1000 point drop is quite another matter.
At 2.20Pm the Dow was at 10,460 and then suddenly in 7
minutes it shed another 600 points. Humans could never move
that fast. There are rumours that a trader entered billion
instead of million and this triggered the massive sell off.
Whatever the cause the main wave of selling was initiated by
computers.
A simplified look at quant model
A Quant (Quantitative) programme is a computer model which
determines which investment strategy is going to yield a
superior rate of return; to simplify matters let’s assume
the programme decides when to go long or short.. It is
assumed that because computers have no emotions, they should
be better at trading as they can move in and out of the
markets extremely rapidly. The scary part is that the
computer renders the final decision. There is one problem,
these computers are programmed by humans and one glitch in
the programme can cause havoc. Let’s not forget the old
saying junk in junk out. Today’s wild action is indicative
of what can go wrong when computers take over.
These quant programs now make the vital function of market
marker almost obsolete and this is a very dangerous
situation if left unchecked. Today Treasuries, SP500 and
other indices were moving so fast it was hard to manually
follow them. Computers took over the markets for a few
minutes and in that time they wrecked total havoc. What
happens if the glitch is not spotted immediately, then a
cascade of sell orders could be triggered pushing the Dow
down until the circuit breakers kick in. However, if the
glitch was not found then computers would resume selling
after the markets opened again. Let’s not forget that big
firms can still sell via Dark pools. They are
basically electronic networks that allow big firms to sell
stocks without tipping their hand; in other words, they can
sell these stocks anonymously without the public ever
knowing. This is a separate topic, and we will try to cover
it another day. Two examples of firms offering such services
are Liquid net Inc., Pipeline.
Quant strategies are becoming extremely popular. They are
now accepted in the investment community and even mutual
funds are now using these models. These models are also
known as alpha generators, or alpha gens. These programs are
often set up in advance so that the computer can react
instantaneously to moves in the market. For example, if the
Dow drops below a certain level, the programme can unleash a
massive sum of sell orders and in doing so trigger other
quant programs. This could potentially trigger a market
meltdown as was experienced today. Indeed by some counts
computers are responsible for as much as 70% of daily
trading volume.
These models are now a real threat to the health of the
financial markets and should be eliminated or closely
monitored and regulated. Exchanges should not cater to firms
that are using these programs and openly allow computers to
place orders for millions and or billions of dollars.
Exchanges should place a dollar limit on trades that can be
initiated by such programs. One can only imagine what would
happen if the computer mistakenly places a trillion dollar
sell order. Today’s action is a warning, next time things
could be infinitely worse. At one point ACN fell from 42.30
to 4 cents, that is 4 cents; it ended the day at 41.08 down
$1.08. PG shed $23 dollars in a heartbeat but closed the
day down only $1.41. In between someone could have had a
heart attack. Imagine you had 1 million dollars in ACN, and
then suddenly watched your portfolio shrivel right in front
of your eyes as ACN fell to 4 cents from 42 dollars.
One of our first warnings came from Long term capital (LTC).
LTC founded in 1994 was one of the most famous Quant based
funds and it was run by two noble prize winning economists:
The Quant model did not foresee the Russian government
defaulting on its own debt and this triggered a series of
events that destroyed LTC. In less than 4 months in 1998
LTC lost 4.6 billion dollars. If the Feds had not stepped
in, things could have really turned ugly.
These quant trading programs need to be regulated and not
allowed to freely take over the markets; they are destroying
the vital role market makers play to maintain financial
stability in the markets. Today’s action should serve as a
wake up call for those who have turned a blind eye to risks
these programs pose to the markets. Next time round we might
not be so lucky.
On a separate note we warned individuals about the dangers
poised by the extremely low volume in an article that was
just published one day ago
Precipitously Low Market Volume a Sign That Correction Is
Imminent 7 comments
The key to the age may be this, or that, or the other, as
the young orators describe; the key to all ages is --
Imbecility; imbecility in the vast majority of men, at all
times, and, even in heroes, in all but certain eminent
moments; victims of gravity, custom, and fear.
Ralph Waldo Emerson, 1803-1882, American Poet, Essayist
|