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June 1, 2010

Market Madness

By Dan Mathisson

There are a few ways to attack this problem. The exchanges and regulators are currently focused on installing "circuit breakers," automatic trading pauses that trigger in the event an air pocket is hit. The latest plan calls for trading halts triggered by any trade outside of a designated price range, followed by an opening auction a few minutes later. As long as the pauses are long enough to give people time to examine their orders and make trading decisions, the circuit breakers should be effective. But one problem with halts based on prints is that they don't trigger until after there's already been a bad print--the equivalent of having the troops put on Kevlar vests only after the first soldier has been shot.

More elegant would be a futures-style limit down, which simply doesn't allow trades below a certain level, until some amount of time has passed, and then the level is reset. With limit down, the bad trade would be stopped before it happens, making "clearly erroneous" trade breaks announced at 7 p.m. a thing of the past. A limit-down system is the most conservative, the equivalent of wearing bullet-proof vests before anyone's been hit.

But while circuit-breakers or limit-down mechanisms can certainly minimize the damage caused by erroneous bullets, if the bad order is still not cancelled, the stock may just plummet again after the re-open. Wouldn't it make sense to try to stop the bullets from being fired in the first place? The best way to do that is to remove the gun: Eliminate the market order. Make retail investors think about the lowest price where they would really be willing to sell, including mandating price limits on stop-loss orders. Investors in Germany, Brazil, Hong Kong, and many other major markets are already limited to limit orders. Without market orders, investors can still aggressively trade-they can type in a price that's a dollar below the current price, or even $5 below. But make all orders have some boundary, so that in the event the bids all fade in a perfect storm of market madness, professionals will be less likely to have a career-ending fat finger, and investors will be less likely to shoot themselves in the foot.

 

Dan Mathisson, a managing director and the head of Advanced Execution Services (AES) at Credit Suisse, is a columnist for Traders Magazine. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

 

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