Metric predicts stock market 'flash' crashes

Dec 03, 2010 By Linda Glaser

The May 6, 2010, stock market crash briefly erased almost $1 trillion in value and plunged the Dow Jones Industrial Average into its biggest intraday fall ever. The market recovered most of its losses within the hour, but the crash left the financial world reeling.

This kind of "flash crash" is now predictable, and possibly preventable, thanks to a new formula developed by David Easley, the Henry Scarborough Professor of Social Sciences and chair of the Department of Economics, and Maureen O'Hara, the Robert W. Purcell Professor of at the Johnson School, in collaboration with Marcos López de Prado, head of high frequency futures at Tudor Investment Corporation.

The new so-called volume-synchronized probability of informed trading (VPIN) looks at the imbalance of trade relative to the total volume of the market. It identifies flow toxicity, which Easley and O'Hara have been researching for about 20 years.

"Flow toxicity refers to the risk that liquidity providers face when trading with traders who have better information than they do," explained Easley. The flow of orders "is considered toxic when traders are selling when they'd rather be buying, and buying when they'd rather be selling."

Flash "events" -- short-term illiquidity crises in the market -- occur when market makers suddenly stop trading in response to a high level of flow toxicity, resulting in a sudden drop of prices.

"All morning long on May 6 order flows were becoming increasingly unbalanced, and volumes were huge," said O'Hara. "An hour or more before the flash crash our measure hit historic levels."

The VPIN could prevent future flash crashes by giving market regulators warning of flow toxicity early enough that they could slowly adjust the market, said Easley.

The metric could also give traders a way to hedge the risk of flash crashes, so that they don't have to be as concerned with the value of their inventory plummeting. "We believe that's what caused so many of the high frequency market makers to get out of the market during the flash crash," said Easley. "They were taking huge losses, and they didn't know exactly what was going on. They reached position limits so they quit. And if they could have hedged that risk, perhaps that wouldn't have happened or the results wouldn't have been so severe."

O'Hara serves on the Joint Commodity Futures Trading Commission-Securities and Exchange Commission (CFTC-SEC) Advisory Committee on Emerging Regulatory Issues established after May 6. "One of the problems that regulators face now is that markets are so fast that regulating after the fact is really too late," she said. "One of the advantages of our measure is that it is forward looking, so it could be a useful tool." Both the CFTC and the Financial Industry Regulatory Authority advising board have expressed interest in the VPIN. Private firms, such as Tudor Investments, have also used O'Hara and Easley's research to develop trading algorithms for high-frequency markets.

"Research on these things is extremely important because when markets falter the whole economy is affected," said O'Hara, who also studies market fragmentation and information flow to traders.

Easley, who is also a member of the Department of Information Science, recently co-authored "Networks, Crowds and Markets: Reasoning About a Highly Connected World" with computer science professor Jon Kleinberg. The book takes an interdisciplinary look at the new science of networks.

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User comments : 3

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rwinners
not rated yet Dec 03, 2010
Ridiculous. The answer, the only answer that will bring the average American capable of investing back to the market is to remove computer based 'flash' trading from the mix.
These people are gaming the system and that needs to stop. Period. Regulating or otherwise trying to 'manage' the gaming is going to leave Wall Street playing with itself.
VOR
not rated yet Dec 05, 2010
Except for a few retail brokerages, wall street doesnt care if 'average american' is directly involved. People will still be involved through less direct means such as funds. But Im not endorsing high speed trading. Its an unfair sort of
'time arbitrage'. They should defeat it by requiring short buffer times for trades to match, or something like that-slowing things down just a little so their speed advantage is removed. some kind of partial fix will probably eventually happen, like the price increment change that happened. May take years.
rwinners
not rated yet Dec 06, 2010
There are a good number of 'retail' brokerages, particularly those that are web based, who do care about small investor involvement in the market.
And they need to do something about the money center banks and their affiliates who cater to, as stated above, "Time Arbiters".
I do not want to pay even a fraction of a cent more on a transaction because someone has a hand in the middle of it. Sucks!

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