There is now pretty convincing reporting that a single trader on the EMini indeed started last Thursday’s market bungee jump. An Overland, KS fund manager submitted 75,000 EMini orders during the key time period. The firm in question, Waddell & Reed, has issued a statement. Here’s the key bit:
On May 6, as on many trading days, Waddell & Reed executed several trading strategies, including index futures contracts, as part of the normal operation of our flexible portfolio funds. Such trades often are executed in response to market activity, and are undertaken to protect fund investors from downside risk. We use futures trading as part of this strategy, broadly known as hedging.
Portfolio insurance–the replication of puts on portfolios using dynamic trading strategies–is a strategy intended to protect fund investors from downside risk. It is a strategy that is executed in response to market activity; prices move, leading the portfolio insurer to trade to keep the delta match; the insurer chases the market (which is how, in effect, it pays the option premium). The W&R statement could therefore be describing a portfolio insurance strategy, or something quite similar. (Placing stops at different price points effectively does the same thing.)
Done in an illiquid market, especially in the size indicated (with one firm trading more in less than an hour than the EMini market usually does in an entire hour), this could start the feedback loop that exacerbates market movements.
All of this is completely in line with my earlier conjectures: (1) big trades in a market index were likely to be the precipitating factor, and (2) positive feedback trading strategies were involved.
Again, though, the fascinating–and comforting thing–about this episode is that whereas in earlier episodes (e.g., ‘87, ‘29), the market crashed and then went “splat”, this time it bungeed back almost immediately. That’s what sets this episode apart, and I hope that regulators and exchanges make sure they understand why that happened so it can recur in the future if need be, and so they don’t do something stupid that would not materially reduce the possibility of the market from going non-linear but which would prevent rapid self-correction like that which occurred on the 6th.
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