May 24, 2010
My Take on Circuit Breakers
Posted Online 5/18/2010
First things first what are circuit breakers? They are an automated shut off switch place on trading of a specific equity after a fall of X percentage or amount over Y period of time or from a specified point. I believe the current proposal is 10% change over 5 minutes of time. And its going to likely be to the top side too.
Lets talk about why circuit breakers are on the table to begin with the infamous Flash Crash. Technical Traders and High Frequency Traders all knew that the 1150 mark on the SP was a crucial support level therefore if that support level was broken they wanted to get out of their long positions. So they set their stops and algorithms to exit their long positions if that level is broken.
Then the next major support level on the SP was that 1080 level. This is an area where Technical Traders and High Frequency Traders wanted to buy the stock. So they set up their trading platforms to buy against this level. If this level would have been broken there would have been even more substantial of a sell off but this level held as support so we went higher from there. The problem now is that the technical damage has been done. That move destroyed some important support levels and the nearest strong support levels on the SPX are 940, 880, and then 550 if we get there.
The media has gone back and forth with several theories about what happened but thats it. It was just a key technical level where many sell orders were placed. It was NOT a fat finger. The media constantly sees price move THEN looks for the scapegoat to give the general investor a sense of security. A lot of what they say is just an explanation but not the truth.
(FACT: American markets and equity markets generally have a higher proportion of algo trades than other markets, and estimates for 2008 range as high as an 80% proportion in some markets (http://en.wikipedia.org/wiki/Algorithmic_trading).)
So theres a little background on why the regulators are now talking about putting in a circuit breaker system. I didnt cover all the details but the basis is that most people think it was an uncontrolled drop in price, when in reality it was calculated and almost perfectly corresponded with support levels that were either broken or held.
Now lets talk about why the circuit breakers will harm the general investor and also why it will be supported by the general investor. The primary reason why the general investor will be harmed is that if one of these circuit breakers goes off there is not exit door. Its the equivalent of the close of the trading day. Have you ever had a stock gap against you? When the pause is over there is no guarantee that the stock price will have not changed. The bid and ask will move, the market will change. In essence it will be like a mini-overnight period for the stock.
It will be supported by the general investor because it gives them a false sense of security. Its like a baby blanket. Its warm and it feels good, but thats about it. Circuit Breakers will only offer limited protection and may even be detrimental, in that price can gap. Some High Frequency Traders may support it because the Flash Crash gave them a negative public image. It buys the High Frequency Traders some time before they hike the traders tax. Remember, High Frequency Traders wont be affected that much by this rule as if one stock gets paused out theyll just move on to the next stock just before it hits that 10% mark its just a minor inconvenience.
Now, I cant be completely negative on Circuit breakers. Im sure some positive things will come from them. They may be effective at slowing the process down and well soon find that out. As a High Frequency Trader myself I will figure out a way to use the pauses to my advantage. Im sure there will be gaps that need filling and reversals that happen, just like can happen over night. Its going to change the game and those that figure it out first will benefit most from the changes coming down the line.