High-Frequency Trading: 'Circuit Breaker' Remedy Aimed At Avoiding Flash Crash Debacles Caused Market Mayhem In Sell-Off

It was a rare case of the cure being worse than the disease. At least some of Monday morning's extreme market volatility can be traced to recently implemented federal regluations.

Investors woke up Monday to see wild price swings and extraordinary market volatility. More than 1,000 points evaporated from the Dow Jones Industrial Average and the Standard & Poor’s 500 index plunged 5.3 percent in the first four minutes after the opening bell, before quickly recovering about half of what was lost. More than 2 billion shares traded hands in the first half-hour.

Trading volume was so high and moved so quickly that it led many to ponder whether electronic high-frequency trading played a role. But experts say reforms meant to prevent algorithms from causing volatility contributed to Monday morning's unusual trading patterns. The high-speed trades had a profound impact on exchange-traded funds (ETFs), an increasingly popular way for investors to hedge their bets against other investments.

On its face, the recent massive sell-off of U.S. stocks makes sense. Global markets are shaky as a reaction to growing concern over a slowdown in China, an economy that has been gobbling up a massive share of the world’s goods, from iron ore and copper to BMW vehicles and Hermes handbags. That party is over, for now.

High-frequency trading uses computer algorithms to execute high-speed trades characterized by extremely high volume, short-term investments that last a matter of moments. By some estimates, electronic high-frequency trading accounts for as much as 73 percent of daily market volume on U.S. exchanges. Monday’s massive high-volume sell-off would have been no different, though automatic trading’s role in the sell-off is unclear.

Like Ticket Scalping

In the documentary "The Wall Street Code," Haim Bodek, managing principal at Decimus Capital Markets likened high-frequency trading to concert-ticket scalpers who can teleport to the front of a long line of concertgoers the second a box office opens. In that analogy, the opening of the box office is when a stock price changes.

Joe Saluzzi, a partner at institutional agency broker Themis Trading, said Monday’s volatility and flaws in the way markets handled the massive high-speed sell-off led many traders to sell stocks and ETFs at prices lower than they should have.

“Some ETFs were trading as low as 50 percent below where they closed on Friday,” he said. “A lot of people got hurt by their ETF trades.”

Like mutual funds, ETFs are composed of a basket of stocks. But unlike mutual funds, ETFs are traded like individual stocks whose prices swing throughout the day. Retail investors like ETFs because these securities are linked to a collection of stocks and are not dependent on the performance of individual companies. ETFs were designed to make it easier for average people to buy into the market.

But on Monday, Saluzzi says, the way the markets handled the massive sell-off gouged many investors whose brokers had trouble buying and selling ETFs right before and after the opening bell. And the reasons for that have a lot to do with what happened in the wake of the May 6, 2010, "flash crash" caused by high-frequency trading.

The "flash crash," in which the Dow plunged almost 1,000 points in minutes before quickly recovering, led to congressional hearings and, earlier this year, the arrest of Navinder Singh Sarao, a west London high-frequency trader who could be extradited to the U.S. next month to face charges for allegedly using high-speed trading manipulations to earn him more than $40 million in less than 40 minutes.

In the wake of the "flash crash," the U.S. Securities and Exchange Commission forced markets to impose so-called circuit breakers. These mechanisms automatically interrupt trading of individual stocks or ETFs for five minutes if their prices swing 10 percent in either direction within five minutes.

Circuit Breakers Went Wild

And on Monday, there was so much volatility and a mad rush to sell, that the circuit breakers aimed at fighting high-frequency trading went wild. They were triggered nearly 1,300 times before and after the opening bell Monday, including 999 times on the New York Stock Exchange’s Arca fully electronic trading system.

With so many five-minute trading halts, open prices for ETFs were impossible to determine by the time the daily session kicked off at 9:30 a.m. in New York City. Many ETFs were sold at steep discounts after the bell rang, only to see their prices bounce back in a matter of minutes. The ETFs were particularly affected by the circuit breakers because they contain individual stocks on which trading was interrupted. The New York Stock Exchange invoked its rarely used Rule 48, which suspended the requirement that stock prices be announced before the opening bell.

And because of this swarm of little trading interruptions from the circuit breakers, many individual stocks, like Home Depot Inc. (NYSE:HD) and General Electric Company (NYSE:GE) were trading far below their previous day’s closing price only to see their prices quickly rebound. That meant many people sold stock or dumped ETFs early in the day at lower than their real market values. Other traders snatched up these stocks, which led to a midday rebound before the markets closed in the red Monday.

How much of a role electronic high-frequency trading played in exacerbating Monday morning’s mayhem will likely never be known for certain. We do know that the circuit breakers implemented after the 2010 "flash crash" clearly created confusion about the real price of stocks, but that’s more of a reflection of the reforms aimed at curbing the effect of high-frequency trading and not high-frequency trading itself.

Analysts say that the fundamental reason for the massive sell-off in global and U.S. markets is a real reflection of investors' concerns that the global economy is slowing, rather than an out-of-the blue massive midday plunge like the 2010 "flash crash."

“I don’t think yesterday was a 'flash crash' or some high-frequency trade debacle,” said Dave Lauer, co-founder and chief technology officer of market research firm Kor Group, which advises clients on how to navigate evolving trading technologies. “It seems like things were functioning normally, although with a lot of volatility. What do you expect when you have a huge amount of selling and people wondering what the f--- is going on?”