Create Your Own Circuit Breakers…

The SEC announced Tuesday the creation of temporary “circuit breakers” to be placed on ALL stocks in the S&P 500 Index (SPX) after a 10-day comment period and through December 10, 2010. The circuit breakers will pause trading in the stock for five minutes if the price moves by 10% or more in a five-minute period.

The NYSE has a “broad market” or index-based circuit breaker, which pauses or halts trading when an entire group of stocks, specifically the Dow Jones Industrial Average, drops by 10%, 20%, or 30%. All of these moves trigger different actions depending on the time of day that the selloff occurs.

The issue here is that the circuit breaker is based on the entire basket of 30 stocks contained in the Dow and while the average is supposed to be a proxy for the much broader markets, there are more than 6,500 publicly-listed companies on U.S. exchanges.

As we all know, diversification should reduce risk. If you were to purchase a group of 30 stocks in your account, the chances of one of them being down 10% or more is greater than the chances of all of them being down the same amount (of course this works when stocks are moving higher as well). The point is that while diversification helps the portfolio or index as a whole, it has minimal effect or control on the individual components within. You could have the entire group of stocks only down 10% collectively, but have an individual stock that is down 30%, 40%, or more.

As the bulk of trades made today are electronic and many of them are based on automated algorithms and formulas, the intervention of the human hand in most trades is nil. According to the NYSE and NASDAQ, high-frequency trading now accounts for 65-75% of average daily trading volume. High frequency trading (HFT) is also algorithmic in nature and uses ultra-low latency to process orders extremely rapidly as traders try to get ahead of order flow and capture very small amounts of profit on a massive volume scale. Because HFT firms employ a number of different strategies, is hard make a blanket statement that all HFT trading is good or bad or rule on whether it exacerbates or mitigates volatility.

In my opinion and from my personal experience, electronic trading does certainly speed up the process at which orders get executed, but without the human element, prices can move to extremes as the humans move out of the way and the algos do their thing (computers don’t “think,” nor are they rational).

I remember my life as an open outcry market maker in the pit; we would collectively agree on a price and do our best to take down an entire customer order — sometimes 10,000 options contracts at one price. In the all-electronic world, single price execution may be less common as computers and algorithmic pricing may fade the bid or offer prices extremely quickly, resulting in higher volatility. I have to be fair and note that there are certainly firms out there who regularly strive to take down large size orders at a single price and typically do so.

But you can’t really motivate a computer to fill your entire order at one price, as it doesn’t have a brain or opinion on where the market is going. As such, there is no way for it to rationalize the decision to do the trade or pass. It just runs a program: if x=1, then Y=2, etc…

Obviously, high liquidity, blue-chip names that are traded by many different market participants enable large size trades to be completed at one price more frequently than a thinly traded stock. It’s when the markets begin to move that real liquidity and stability come into question, in my mind.

What happened on May 6, 2010, I believe, was a product of the flaws of both the electronic and algorithmic majority that rules the markets, combined with a not-so-perfect link (rules and technology) that exists between primary, secondary, and derivative/futures exchanges.

Regardless of what causes volatility and crashes, you should have your own “circuit breakers” in place on your individual stocks, options, and ETFs. The good news is that you don’t have to wait for the SEC or exchanges to do something. A “circuit breaker” can be a stop-loss, a trigger order, a long put on your long stock (or a long call on your short stock), or some other hedge strategy (if you’re a more savvy investor).

Having a stop order in place can hedge your position and potentially limit your downside in a sharp, fast intraday selloff (or rally if you are short). One thing to remember is that stop-loss orders and stop-limit orders are very different in how they behave and if you are using a stop-limit order, there is a chance you will not be taken out of your trade as it triggers a limit order and the stock can continue right on through your limit price, while the stop-loss triggers a market order, ensuring that you exit your position, assuming the stock is still trading. Unfortunately, even with both types of stop losses, there is still susceptibility to slippage during market hours. When things just go bonkers and markets (bid/ask spreads) begin to widen and make drastic moves, you may be stopped out prematurely or at a price far away from your stop trigger price. Unlike many of the orders that were cancelled on May 6, your trade may still stand, leaving you very unhappy.

In addition, if a stock, index, or ETF gaps up or down while the market is closed, stop orders may NOT hedge your positions. This is where an option may offer the hedge you require. If you are long stock at $50, for example, and you purchase the 45 put for $1, your max risk is $6, no matter how far the stock drops and whether it happens intraday or overnight. (Risk = (stock cost -put strike) + premium paid) The put gives you the right to sell that stock at $45, so your losses are limited as long as you own that put. Also remember that if the stock drops, that put may increase in value and can be sold in the open market for a potential profit.

If you are short stock at $50, the purchase of a 55 call for $1 would have the same risk characteristics (Risk= (call strike – stock cost) + premium paid), although your profit potential is limited in this case to the short stock basis minus the call premium paid.

Check out our education area at the lower-right-hand corner of our home page for more information on how to enter stop orders as well as how to learn the basics of options.

Photo Credit: davef3138

Share and Enjoy: