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Trading flubs flummox investors

Trading glitches are a fact of life on Wall Street. They rarely happen, but when they do they can send shockwaves through the financial markets. A recent spate of them has re-ignited investors’ concerns. — By Roland Jones
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Trading glitches are a fact of life on Wall Street. They rarely happen, but when they do they can send shockwaves through the financial markets. A recent spate of high-profile errors and price distortions in electronic markets has re-ignited investors’ concerns.

Earlier this month, a sharp decline in the popular “mini” Dow Jones industrial average futures contract at the Chicago Board of Trade (CBOT), the number-two U.S. futures exchange, briefly sent the entire U.S. stock market reeling.

The cause of the downturn, which was initially thought to be a trading error, is under investigation by the CBOT.

Futures brokers and trading firm executives had varied views on the events and on whether such incidents are simply a fact of life in the freewheeling, highly computerized trading environment.

“There should be more information given out regarding who has made these trades and why,” said Russell Wasendorf, Chicago-based chief operating officer with Peregrine Financial Group, a futures-commission merchant.

Examples of other big trading glitches — whether they happen as a result of human error or an electronic anomaly — are quite rare, but when they occur they show that even in an age of computerized trading, large-scale market errors can jolt investors and instantly wipe away a large amount of investor wealth.

In October of last year, for example, a trader at Bear Stearns mistakenly entered an order to sell $4 billion in stocks instead of $4 million. And two years ago London’s stock market collapsed after one hapless trader entered an extra zero into a sell order.

“When you have human beings participating in a market you’re always going to see errors,” remarked Michael A. Goldstein, an associate professor in the finance department at Babson College in Massachusetts who has served a one-year term as visiting economist at the New York Stock Exchange.

Goldstein reckons that so-called “fat finger” trading mistakes have probably increased in recent years, as overall trading volume has grown and decimalization — the move to trade stocks in decimals instead of fractions — has meant traders are dealing with many more numbers.

“Investors should be aware that there are human beings at almost every part of the trading process, and they type [on keyboards] the same way the rest of us do,” Goldstein added.

Some inherent dangers seen
As markets have become more automated, technical problems have also taken a toll, prompting some trading professionals to point to the inherent dangers. They also concede that these trading glitches are an unavoidable part of an increasingly automated marketplace that has seen explosive growth in recent years.

On July 14, for example, the Chicago Mercantile Exchange (CME), the largest U.S. futures exchange, saw its E-Mini Standard & Poor’s 500 futures contract — a smaller version of the CME’s benchmark S&P contract — drop briefly, but sharply, in afternoon trading, prompting the exchange to void some 600 transactions.

The trading problem at the CME was not triggered by a trading error, but by an “order imbalance” that led to a “cascading effect” when a number of stop orders were executed in the automated trading system, according to a spokesperson. The sudden decline sent ripples through the U.S. financial markets.

A stop order is an order to sell a stock when its price falls to a particular point, limiting an investor’s loss. The CME plans to introduce new measures to prevent any similar moves by future stop-loss orders.

In both the CME case and the trading problem at the CBOT, exaggerated price movements in futures markets led to sharp declines in the equities markets, according to Phil Flynn, senior market analyst with Alaron Trading.

The main reason for the spill-over is that financial markets have become ever more interconnected in recent years, Flynn explained, adding that investors in the stock market have come to rely on the futures market as a leading indicator for the movement of stocks.

Flynn sees this month’s dramatic price swings in the stock index futures markets at the CME and the CBOT as showing the dangers inherent in markets that are only traded electronically, which have seen explosive growth.

“At the Merc there was an order imbalance and no one was there to control it,” said Flynn. “In the old days, when you sent a goofy order down to the floor you’d get a call back to ask if you’re sure you want to place this or that trade. There was an extra set of eyes.”

Flynn points out that in the open outcry trading system, when traders make verbal bids and offers with one another in trading pits, means that when there is an order imbalance on the trading floor independent floor traders can take the other sides of those trades, creating liquidity in the market and smoothing out the trade imbalance.

Reuters contributed to this story.