How a Trading Algorithm Went Awry

Flash-Crash Report Finds a 'Hot-Potato' Volume Effect from Same Positions Passed Back and Forth Oct. 2, 2010, Wall Street Journals
The eagerly awaited report on the causes of the May !flash crash! portrayed a mar"et so fragmented and fragile that a single large trade could send stoc"s into a sudden spiral. The report, released #y federal regulators on $riday, went further than many in the mar"et had e%pected #y pinpointing one trade #y a mutual&fund company as a "ey contri#uting factor to the mar"et's plunge. (egulators say that the firm) which was O*erland +ar", ,an.&#ased Waddell - (eed $inancial .nc., according to people familiar with the trading)chose to sell a #ig num#er of futures contracts using a computer program that essentially ended up wiping out a*aila#le #uyers in the mar"et. A spo"esman for Waddell refused to comment #eyond the firm's pre*ious statement from May, in which the firm said it doesn't intend to !disrupt! mar"ets through its trading. The 10/&page report #y the staffs of the 0ecurities and 1%change 2ommission and the 2ommodity $utures Trading 2ommission said high&fre3uency traders 3uic"ly magnified the impact of the mutual fund's selling. Among other points, the report shows si% of 12 high&fre3uency trading firms remained in the mar"et as stoc"s #egan to crash. Howe*er, those firms too" !significant! #uying power out of the mar"et. As well, the report plays down the impact of data delays and a shutdown of the lin"s #etween some e%changes, which the 012 directly o*ersees. While the report hadn't #een e%pected to ma"e policy recommendations, it only lightly touched on how rules from the 012 and other regulators set the stage for a mar"et implosion. 0ince May , the 012 is testing rules designed to #riefly halt trading in indi*idual stoc"s during sharp mo*es or to pre*ent them mo*ing #eyond a certain percentage limit. 4oe 0alu55i, co&head of e3uity trading at Themis Trading, an agency #ro"erage, said he was disappointed #y the narrow focus on the large trade, rather than a set of proposals for how to pre*ent a similar crash. !All you got here is fi*e months after the fact, you ha*e an analysis of 16 minutes of trading,! said Mr. 0alu55i. !.f this were to occur again, it would ta"e another fi*e months to figure it out.! The report lays out the #ac"drop to the flash crash, noting May #egan !as an unusually tur#ulent day,! with the mar"ets roiled #y the 1uropean de#t crisis. 7y 2890 p.m. 1astern time, the :ow 4ones .ndustrial A*erage was down a#out 2; points.

At 2892 p.m., a trader at Waddell - (eed placed a huge order to sell 1&mini futures contracts, which mimic mo*ements in the 0-+ 600&stoc" inde%. This "ind of trade wasn't unusual for Waddell, which at the time managed some <26 #illion, including the popular .*y Asset 0trategy $und. As part of the fund's strategy, the firm from time&to&time places #ets that the #road stoc" mar"et will fall as a hedge against its indi*idual stoc" holdings. Also not unusual was that Waddell placed the trade using a computer program "nown as a trading !algorithm! designed to stand in for a human trader and parse out #uying or selling #ased on different *aria#les. =enerally, traders opt for algorithms that consider trading *olume, price changes and the amount of time to complete a trade. 7ut Waddell's des" opted for an algorithm designed to sell ;6,000 1&mini contracts at a pace that would range up to >? of trading *olume)and not ta"e into account other factors. The report details how a similar&si5e trade earlier in 2010 too" fi*e hours to e%ecute, #ut in this case, the Waddell trade unloaded on the mar"et in @ust 20 minutes. As the Waddell trade hit the futures mar"ets, the @oint report said, the li"ely #uyers included high&fre3uency trading firms. A "ey feature of high&fre3uency trading firms is that they 3uic"ly e%it trades and, #y 28/1, they were also aggressi*ely selling the 1&mini contracts they had #ought from Waddell, which was still trying to sell the remainder of its contracts. Meanwhile, long&term #uyers were out of the mar"et in the midst of the selloff. !H$Ts #egan to 3uic"ly #uy and then resell contracts to each other) generating a 'hot&potato' *olume effect as the same positions were passed rapidly #ac" and forth,! the report says. At one point, H$Ts traded more than 2;,000 contracts in @ust 1/ seconds)a huge amount. The Waddell algorithm responded to the high *olume #y pic"ing up the pace of its selling, e*en though stoc"s were spiraling lower. This feed#ac" loop of selling #y Waddell, high&fre3uency traders and others helped dri*e the 1&mini price down 9? in @ust four minutes. The report cited this episode as a !"ey lesson! of the report8 !1specially in times of significant *olatility, high trading *olume is not necessarily a relia#le indicator of mar"et li3uidity.! A 2$T2 official called the e%ecution of the trade !unfortunate! and said it !effecti*ely resulted in the erosion! of li3uidity in the 1&mini contract, which was e%acer#ated #y other mar"et players. He said it wasn't clear whether the flash crash would ha*e #een a*oided without the trade. 2M1 =roup .nc., operator of the futures e%change, 3uestioned the report's focus on the large 1&mini trade. !The report . thin" is s"ewed wrong, #ecause

it tal"s too much a#out that AtradeB, #ut if you read it, you see our mar"et wor"ed,! 2M1 2hairman 1meritus Ceo Melamed said. The selloff in the futures mar"et then spilled o*er to the mar"et for indi*idual stoc"s. And as conditions worsened, the li3uidity in the mar"et e*aporated #ecause the automated systems used #y most firms to "eep pace with the mar"et paused when prices #egan falling drastically. O*erall, the report painted a nuanced picture of the role of high&fre3uency trading firms, some of which ac"nowledged pulling out of the mar"et that day. 0ince May , regulators ha*e 3uestioned whether these superacti*e traders should ha*e any o#ligation to "eep trading amid a crisis. $riday's report found that of the 12 largest high&fre3uency firms, si% scaled #ac" trading during some portion of the afternoon's plunge. .n addition to se*eral firms pulling out of the mar"et, those remaining !escalated their aggressi*e selling! during the downdraft. While focusing on the role of Waddell and high&fre3uency traders, the report went easier on stoc" e%changes, which the 012 regulates. The report said delays in data from the Dew Eor" 0toc" 1%change's electronic& trading arm, Arca, contri#uted to some traders' !decision to curtail or halt trading.! The DE01's decision to !go slow,! or switch trading in some stoc"s from electronic to human auction, didn't cause significant difficulties in order& routing #ut did spoo" participants and played into their decision to pause trading or withdraw from the mar"ets, the report said. And the mo*e #y Dasda3 OMF =roup .nc. to #ypass DE01 Arca, effecti*ely routing orders around it in response to concerns a#out DE01 operations, added to concerns a#out a#normal trading, the report said. 7ut it concluded that all of these e*ents didn't play a !dominant role! in the flash crash. (epresentati*es of DE01 1urone%t and Dasda3 declined to discuss details of the report. An DE01 spo"esman called it !an important step! in understanding the e*ents of May and !outlining the challenges! in impro*ing the mar"ets, and cited as e*idence of impro*ements recent proposals to synchroni5e e%changes' rules go*erning halting of trades and the o#ligations of mar"et ma"ers