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Elaine Wah

Modern Markets, Modern Metrics - A Blog By IEX

In this blog by IEX's Elaine Wah, the newest public exchange looks to refute public claims that the metrics it uses are designed to inflate its own volume numbers and mislead people.

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December 8, 2008

2008 Review: Volume and Volatility Skyrocket

Turbulent Times

By James Ramage

Whoa, Nellie! What a ride! Huge equity trading volume and historically high market volatility characterized 2008. The accelerant, of course, was the violent market correction stemming from the subprime financial crisis. Starting in September, volume and volatility jumped to record levels after major financial institutions began teetering-some failed and others got bailed out. A subsequent game of musical chairs began among investors, as they asked the question: "Who's next?"

This uncertainty fueled extreme price swings and made trading difficult, leading to erroneously priced trades and delayed market openings and closings. Capital also became more scarce at large trading houses.

The volume was impressive, though. On Oct. 10, almost 20 billion shares traded.

Historically speaking, overall share volume started its ascent in 2004, after recovering from the market decline in 2001. Volume rose to an average of 8.65 billion shares per day this year through October-up from 5.92 billion through the same period in 2007, according to data compiled by Nasdaq and BATS Trading.

Volume for September and October averaged 11.3 billion shares per day and 12.2 billion shares per day, respectively.

In a normal environment, there isn't a direct correlation between increased volatility and volumes. But in extremely volatile times, such as in September and October of this year, the two go hand in hand, according to Bob Barbera, chief economist at Investment Technology Group.

Intense volatility elicits large trading increases because investors find themselves calling into question their investment strategies and asset allocation, Barbera said.

Consequently, many investors moved money out of equities. "We've heard a great many hedge funds face large redemptions," Barbera said. "Large redemptions require them to liquidate large positions."

The level of volatility had been high throughout the year in the wake of the trouble at financial institutions. But it absolutely exploded after Sept. 15.

Volatility is defined as the rapid and extreme fluctuation in stock prices, which originates from uncertainty. And that uncertainty has persisted.

Conditions are generally considered volatile when the Chicago Board Options Exchange's volatility index-or VIX-measures at least 25. By May, 2008 was shaping into one of the most volatile years since the Great Depression. The VIX was clearing 25 routinely, and even hit 32.24 in March after Bear Stearns fell.

In mid-September, the VIX blasted into the stratosphere after Lehman Brothers, Merrill Lynch and AIG made headlines. The VIX eventually reached a record 80.06. It averaged 61.18 for October. That monthly average dusted the previous one-day record of 45.74, achieved 10 years earlier, on Oct. 8, 1998.

There were other market conditions related to volatility that made traders fume. On Sept. 19, a record number of trades executed at "erroneous" prices on the electronic markets. Tens of thousands of trades had to be canceled by NYSE Arca, Nasdaq and others.

Because prices couldn't be refreshed as fast as orders were routed, traders couldn't get accurately priced fills. In response, a unit of NYSE Euronext introduced a service to fix the problem and slow down trading.

NYSE Arca started to incorporate competitors' depth-of-book data into its own depth-of-book feed, which lets it route unfilled orders to multiple price levels at competing markets. That, in turn, gave competing markets a chance to refresh their top-of-book prices, thereby preventing orders from executing at markedly different top-of-book prices.

Another issue was the close. Huge volume and volatility created imbalances at 4 p.m., causing delays when closing certain stocks at the New York Stock Exchange. Several days in October saw imbalances in particular stocks, and nervous specialists spent the extended time hoping to offset those imbalances after the 4 p.m. close.

To address this, the NYSE in early October extended its Rule 48, which allows it to declare an "extreme market volatility condition" at the close. Rule 48 permits the solicitation of interest to offset large imbalances after normal trading hours.

Finally, severe market volatility discouraged trading houses from committing capital to the buyside. Gyrating prices, one former bulge bracket block trader said, make it difficult to hedge a position and increased a broker's risk. Cash was also at a premium at these firms due to the credit crunch, he added. So when capital was used in a trade, it came at a steep price.

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