The dangers of Quant Trading models; Dow’s 1000 point drop a prime example

Build a system that even a fool can use, and only a fool will want to use it.
George Bernard Shaw, 1856-1950, Irish-born British Dramatist

The initial trigger for drop in the Dow was probably due to fears that the Greek crisis was going to spread. One could credit this for 300 or maybe even a 400 point drop in the Dow; however, a 1000 point drop is quite another matter.

At 2.20Pm the Dow was at 10,460 and then suddenly in 7 minutes it shed another 600 points. Humans could never move that fast. There are rumours that a trader entered billion instead of million and this triggered the massive sell off. Whatever the cause the main wave of selling was initiated by computers.

A simplified look at quant model

A Quant (Quantitative) programme is a computer model which determines which investment strategy is going to yield a superior rate of return; to simplify matters let’s assume the programme decides when to go long or short.. It is assumed that because computers have no emotions, they should be better at trading as they can move in and out of the markets extremely rapidly. The scary part is that the computer renders the final decision. There is one problem, these computers are programmed by humans and one glitch in the programme can cause havoc. Let’s not forget the old saying junk in junk out. Today’s wild action is indicative of what can go wrong when computers take over.

These quant programs now make the vital function of market marker almost obsolete and this is a very dangerous situation if left unchecked. Today Treasuries, SP500 and other indices were moving so fast it was hard to manually follow them. Computers took over the markets for a few minutes and in that time they wrecked total havoc. What happens if the glitch is not spotted immediately, then a cascade of sell orders could be triggered pushing the Dow down until the circuit breakers kick in. However, if the glitch was not found then computers would resume selling after the markets opened again. Let’s not forget that big firms can still sell via Dark pools. They are basically electronic networks that allow big firms to sell stocks without tipping their hand; in other words, they can sell these stocks anonymously without the public ever knowing. This is a separate topic, and we will try to cover it another day. Two examples of firms offering such services are Liquid net Inc., Pipeline.

Quant strategies are becoming extremely popular. They are now accepted in the investment community and even mutual funds are now using these models. These models are also known as alpha generators, or alpha gens. These programs are often set up in advance so that the computer can react instantaneously to moves in the market. For example, if the Dow drops below a certain level, the programme can unleash a massive sum of sell orders and in doing so trigger other quant programs. This could potentially trigger a market meltdown as was experienced today. Indeed by some counts computers are responsible for as much as 70% of daily trading volume.

These models are now a real threat to the health of the financial markets and should be eliminated or closely monitored and regulated. Exchanges should not cater to firms that are using these programs and openly allow computers to place orders for millions and or billions of dollars. Exchanges should place a dollar limit on trades that can be initiated by such programs. One can only imagine what would happen if the computer mistakenly places a trillion dollar sell order. Today’s action is a warning, next time things could be infinitely worse. At one point ACN fell from 42.30 to 4 cents, that is 4 cents; it ended the day at 41.08 down $1.08. PG shed $23 dollars in a heartbeat but closed the day down only $1.41. In between someone could have had a heart attack. Imagine you had 1 million dollars in ACN, and then suddenly watched your portfolio shrivel right in front of your eyes as ACN fell to 4 cents from 42 dollars.

One of our first warnings came from Long term capital (LTC). LTC founded in 1994 was one of the most famous Quant based funds and it was run by two noble prize winning economists: The Quant model did not foresee the Russian government defaulting on its own debt and this triggered a series of events that destroyed LTC. In less than 4 months in 1998 LTC lost 4.6 billion dollars. If the Feds had not stepped in, things could have really turned ugly.

These quant trading programs need to be regulated and not allowed to freely take over the markets; they are destroying the vital role market makers play to maintain financial stability in the markets. Today’s action should serve as a wake up call for those who have turned a blind eye to risks these programs pose to the markets. Next time round we might not be so lucky.

On a separate note we warned individuals about the dangers poised by the extremely low volume in an article that was just published one day ago and at that time suggested opening up positions in DOG and or  QID. Precipitously Low Market Volume a Sign That Correction Is Imminent 7 comments

 

The key to the age may be this, or that, or the other, as the young orators describe; the key to all ages is -- Imbecility; imbecility in the vast majority of men, at all times, and, even in heroes, in all but certain eminent moments; victims of gravity, custom, and fear.
Ralph Waldo Emerson, 1803-1882, American Poet, Essayist

 

 

 Tactical Investor

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Becoming a better Investor

When you recognize and understand your weaknesses that is when you can truly begin to focus on your strengths.

Sol Palha

One of the main functions of the market update is to identify new trends and not only is this a time consuming task, but it’s also a difficult task. It’s a difficult task because one has to go against the herd; one has to on many occasions even go against one’s own way of thinking because one is embracing a concept that one’s own nature will naturally try to rebel against. The reason for this struggle is due to the fact that we are wired to seek the company of others; we feel safety in numbers. This may be true when it comes to real life dangers but when it comes to investing it’s a fatal error.

Once the trend has been identified, we offer suggestions on what to do and in most cases put out trades that help traders capitalize on our observations.  In fact, if one just focused on the main issues we have discussed over the years, the end result would have been quite profitable. For example, we focused quite a bit on Palladium from the end of 2008 to early 2009. In the bullion portfolio, we had the label screaming buy up several times when Palladium was trading in our suggested entry ranges. Subscribers know that we do not often use the phrase screaming buy, so when we do it usually means that we think we have a unique situation at hand that won’t last long.

Towards the end of 2008 we also spoke of the potential for bonds to mount a very strong correction and warned individuals against opening new long positions.  Bonds mounted one of their strongest corrections ever and by June of 2009, they were down over 20%; a massive move for the bond market. 

From roughly the end of 2008 towards the beginning of 2009 we spoke of the fact that the market was going to mount a strong rally as the plunge was overdone, and that it was trading in the extreme zones. Again patience and discipline were needed, for the markets did not turn around immediately. We issued our final targets of 10,500 plus for the Dow in February; at that time, everyone thought the world was going to end.

We also spent a lot of time talking about the Dollar mounting a strong rally and gold pulling back. Again individual could have jumped out of other currencies into the dollar, closed out some of their long positions in gold and so on. We could list many such stories; however, that’s not our goal here.

Towards the end of the 2009 we started to focus heavily on the markets pulling back. This is the reason we started to actively close out many of our positions and its also the reason we tightened many of our stops. So far, we have had a brief taste of what lies in store, but the main move has not begun yet. Most will wait until it’s too late to react, very few have the patience to take profits and wait for a better opportunity.

Why are we bringing this up? Well, it’s not to talk about our timing skills. Our goal here is to illustrate that most individuals are lacking when it comes to patience and discipline; most individuals want to chase every single opportunity or at least what they deem to be an opportunity. To most opportunity means following the herd. They feel that if they pay for something they should get maximum usage out of it regardless of whether they win or loss. 

To illustrate this point, try this simple exercise.  Choose a day and try to do nothing for 1-2 hours and by nothing we mean absolutely nothing. Very few will be able to achieve this. In fact, most will find that it’s really hard to do absolutely nothing. (Doing nothing does not mean watching TV, reading book, playing games, etc., it means doing nothing).  However, many can run around the whole day trying to do something but achieving nothing. So in reality the truth comes down to this. As long as one can fool oneself that one is doing something (even if one is achieving nothing in the process) its fine, but to actually sit down and do nothing, now that is a terrible and undoable deed. Now apply the above concept to investing and see how true it is. Many feel that they should try to do something all the time, even if they achieve nothing or even loss money in the process, its fine because they are doing something; sitting down, doing nothing and waiting for an opportunity to present itself, now that is simply unimaginable.  

Patience and discipline are the most important traits any trader can hope to master. Would it not be much easier to focus on your real needs and not your fantasies? Why not sit down and look for 1-3 great opportunities (luckily we have managed to do this every year) and wait for the trades to come to you instead of chasing them 

We are almost positive that if we stated that after finding 6 plays that produced 30% or more in gains, we would not issue any more updates for the year, most of the subscribers would throw a fit and want to cancel their subscriptions.  This clearly illustrates the principle of wanting to get something even though nothing might be achieved by forcing a move. The wise man is happy if he can find 1-2 good opportunities a year. There is no need to chase them, just wait for them to come to you. Sometimes you have to wait a few weeks for them and sometimes months and this is what we focus on. We do not like chasing for it usually leads to trouble. All one really needs is one great opportunity a year and one will achieve spectacular results over the long term.

Is it not funny that most find it difficult to sit down and do nothing for 1-2 hours, but as long as they can pretend they are doing something while achieving nothing they are happy? There is a huge difference between the two, in one you are dealing with reality, in the other reality is eluding you; you are just living in an illusory phase. 

Thus going forward, try to find out what you really want, who you really are, what are your needs, what are your goals and so on? Take the time also to read all the rules we have posted in the pass coded section of our website and most of all focus on trying to become a better trader by having more patience and more discipline.