Just found this great article written by Dennis Dick at Bright Trading as early as January of this year. Looks like the same thing that happened in P&G also happened in Rambus. Basically when certain computer algorithms have their risk parameters breached, they instantly dump all their shares at market. January 4, 2010 HFT Market Making May Lead to a Crash Rambus (RMBS) fell 30% today in a matter of five minutes. It immediately bounced back. The cause for this move was speculated as a trader with a âfat fingerâ. A trader simply messed up and sold too much stock accidentally, causing a swift and violent sell-off. The trades were later deemed erroneous and busted by the exchange. But what if the real cause wasnât just a trader with a âfat fingerâ, accidentally selling too much stock? What if it was something more serious? I believe it is. I believe the real cause for this move is a major concern for our markets. The real cause may have been high frequency market making gone bad. Let me explain. Market making is the practice of quoting both bids and offers on the same security, in hopes of capturing the spread. Market making has existed in our markets since the beginning. Traditionally it was done by floor brokers, floor traders and specialists. With the rise of the internet in the last 1990s, new players emerged in the market making practice. Proprietary traders, and E-traders began to play the game. This led to increased competition and tighter spreads. But in the past five years a new player has emerged, and this player has become dominant, knocking many of the competitors out of the game. This new player is the high frequency algorithmic trader, and itâs not a person, itâs a computer. 70% of our daily volume is now done by algorithmic computer systems. Much of this volume is market making. Why has the HFT computer become such a dominant player? It has to do with their edge. High frequency algorithmic systems have been programmed to step inside the NBBO (National Best Bid and Offer), and be the best bid and best offer. This puts the computer system at the front of the line to be first for execution, and gives the computer the best chance to capture the spread. Unfortunately, this practice is dominated by a few large firms, and they have driven traditional market makers out of the market. If a traditional market maker places a bid, the computer automatically steps in front. In some cases, it steps in front by as little as 1/100th of a penny (a practice called sub-pennying, which is discussed on my website http://www.defendtrading.com). These programs are very predatory and step in front of the NBBO on a constant basis. This has driven liquidity providers out of the market. Our proprietary trading firm, Bright Trading LLC, in the early 2000s, used to account for 2% of the volume on the NYSE. Now we account for just a fraction of that. Our 400 traders used to provide a substantial amount of liquidity to the market. But due to predatory HFT market making practices, we now provide very little liquidity. We are now liquidity takers. The rational is simple, if we place a passive limit order (providing liquidity), the HFT algorithmic programs simply step in front of us. If we do get filled on a passive order, it is almost always because we are wrong. You are sub-pennied when youâre right, filled when youâre wrong. Hence, there is no point to us providing liquidity. Other proprietary trading firms, floor traders, and specialists are in the same boat. There is no way for them to compete with the algorithmic programs, so they donât place passive orders. Without traditional market makers, willing to step up and be the buyer of last resort, we risk having more incidents, like the Rambus incident. Computerized algorithmic market making works in any type of oscillating market, as the computer can keep flipping out of itâs longs, and covering itâs shorts. It works in a trending market, as long as there is some type of choppy trade. The problem lies, when the computer system canât flip out of the position. Most algorithmic systems are programmed with some type of risk parameter. If this risk parameter is breached, the computer will dump itâs position and cut itâs losses. This is what may have happened in RMBS today. An algorithmic system making markets on the long side, got too long, and was unable to wiggle out of the position because of the follow-through in selling pressure. Once it was down so much in the position (the risk parameter was breached), it dumped. This simply added fuel to the fire. That is why the sudden plunge to $16 happened. If you check the chart, you will not see this, because Nasdaq busted all trades under $22. But donât kid yourself, these trades happened, and we should be very alarmed, because it will happen again, and it may happen to the entire stock market. High frequency traders make markets on ALL stocks. As they continue to take dominance, and as more and more liquidity providers are driven out of the market by these HFT predatory algorithms, the likelihood of a crash continues to climb. All it takes is a little bad news, and a breach in the HFTâs algorithmic systemâs risk parameters, and weâre in a lot of trouble. This has happened before, it WILL happen again. Rambus was ONE stock today. Imagine if it was the entire market. Dennis Dick, CFA Bright Trading LLC
are you saying, HFT can abuse exchange rules, because it assured some of these trade will be busted in the end, so it can dump as much as possible before busting rule step in?
I hope a crash happens. those "liquidity providers" will then lose money and we as traders can make lots of money. Just dont get overleveraged as trader.
No thats not what I'm saying. Based on the article, the algo programs have certain risk parameters built into them for protection. When they lose a certain amount of cash, they dump everything at market. Remember, that the the DOW was down about 450 points right before it fell to 1000 points. The HFT programs must have been taking some serious losses after which they rapidly dumped everything when they saw no liquidity in certain stocks that the NYSE had closed.
Surprises me how this is not mentioned more often. The exchanges giving preferential treatment to a select few allowing them to sub-penny orders to front run the NBBO is detrimental to the health of the market. It's amusing to keep on reading how these parasites "provide liquidity".
don't kid yourself. No one is going to stand in on a free fall. The truth is people who don't have a clue how to trade don't know how to deal with a "no bid" market. Which is great for the rest of us.
Excellent post Giucco, thanks. So far Dennis Dick is the only guy that clearly foresaw the potential for what happened on 5/6 based on how RMBS traded for a very brief period of time.
In most of these incidents of a "Flash Crash", the machines were doing exactly what they were programmed to do. Should busts be allowed in these circumstances? Heck, no. For years, you get the benefits of "first-in-line" immediate liquidity, and run over buyers, by using market sell orders. Then, it doesn't work out once, and you get to bust the trade.
That is a ineffectual comment on P&G.... Rambus is a bet on RAM intellectual property - they have constant comings and goings with legal events that can trigger immediate and high levels of volatility. Another example people have used on other threads is DNDN - a speculative and unproven (on a commercial scale) technology that is subject to liquidity, public opinion, policy and FDA issues every day. P&G is a multi-billion dollar conglomerate. Unless you are suggesting these "events" in the equity space were merely preparation for manipulating much larger caps, I don't see any point in further analysis.