Grand daddy of algorithmic trading bites the dust?

The ten minutes of mayhem in the US stock market last Thursday may have involved the oldest form of algorithmic trading – the stop loss order. We do not often think of the stop loss order as algorithmic trading, but that is what it is. If its conditions are satisfied, it executes without seeking any confirmation from the person who placed the order.

These days, it is usually a computer which implements the stop loss order, but even in the old days when a human broker implemented it, the stop loss was an algorithm. Whether the hardware on which an algorithm runs is made of silicon or of carbon is totally immaterial.

When I blogged last week about the dangers of market orders, I did not realize that many of the market orders that executed at absurd prices on Thursday afternoon in the US might have been stop loss orders. When the stop loss limit is breached, the stop loss order becomes a market order and executes blindly against whatever bids are available. This can be a prescription for disaster in fast moving markets as an avalanche of stop losses can eat through the entire order book and execute at penny prices as well.

Ironically, stop loss orders might not only have been a big victim of Thursday’s “flash crisis,” but might have been one of its major causes as well. Stop losses are inherently destabilizing as they aggravate the current trend. By demanding liquidity when it is least available, they degrade market quality. By making investors complacent about risks (the stop loss order is supposed to limit losses!), they tend to make investors reckless. All the more reason why these people ought not to have been bailed out by cancelling trades.

Posted at 10:13 pm IST on Tue, 11 May 2010         permanent link

Categories: equity markets, risk management

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