When The Computer Herds Hit The Exits

"In a 2010 study of the 2010 Flash Crash, the U.S. Securities and Exchange Commission and the Commodities Futures Trading Commission  found that high frequency traders substantially increased volatility during the event and accelerated the crash...The Australian Securities and Investments Commission, the stock regulator in Australia, found in a 2012 study that during volatile markets high frequency traders reduce their liquidity supply and increase their liquidity demands....The Bank of Int'l Settlements looked at foreign exchange markets and concluded in a 2011 study that high frequency traders exacerbate volatility in stressed markets... The UK Gov't Office for Science published a large 2012 study of capital markets around the world and concluded that HFT/AT may cause instabilities in financial markets in specific circumstances...

-High-Frequency Trading: A Bibliography of Evidence-Based Research, March 2015

During the fall of 2005, while working on my research paper Riders on the Storm: Short Selling in Contrary Winds, I read very detailed research presented by Bruce Jacobs on the crash of 1987.  Jacobs laid out the case for portfolio insurance being a major contributor to the 22% one-day record decline on Monday, October 19th.1  

The basic premise of this trading tool was to limit the losses of large money managers by buying stock market futures as the market was rising and selling market futures when it crossed a key threshold. 2

Sounds like a good idea, right? One problem; the fallacy of composition.

The fallacy of composition states it is an error to assume that what is true for a member is true for the whole. In other words, if you and a few friends have a signal to get you out of the market once it drops say 10%, then this should have little to no impact on the entire market. However, if your actions reflect a part of the largest and most informed money in the markets, your impact can now become THE MARKET.

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