Commentary

Tim Quast
Traders Magazine Online News

We're All HFTs Now

In this guest commentary, author Tim Quast looks back at the history of HFT and how the market has evolved to where many firms now fit the definition of high-frequency trader.

Traders Poll

Are you in favor of a pilot program and examination of the rebate system by the SEC?




Free Site Registration

November 1, 2010

Fish Market

How the flash crash has turned stocks into fish

By Dan Mathisson

They are many, yet they move as one. There are few things as mesmerizing as watching a school of fish. For no apparent reason, they all simultaneously turn in perfect choreography, and then the whole mass darts in a new direction. Lately, watching stocks has become similarly mesmerizing, as they have shown signs of schooling behavior since the May 6 "flash crash."

Dan Mathisson

On May 6, the market went nuts. As everyone knows by now, the indices plummeted, volume hit its high for the year, and the volatility index skyrocketed. Less known is that realized correlation also began a rapid climb that day. Correlation is a measure of how much of each stock's performance is linked to movements of the other stocks in the market. Given the crash, the climb in correlation was not a surprise to market professionals. Historically, correlation has moved in tandem with volatility--as markets get more uncertain, stocks tend to move together. In moments of great uncertainty, like the 1987 crash, all stocks plummet together, then in the aftermath, they all roar back together.

But something odd happened after the flash fire was out. As volatility and volume both dropped in the ensuing weeks, and the markets calmed down again, correlation did something it was not supposed to do--it continued to shoot up. Realized correlation had been around 30 percent for most of 2010 prior to May 6. After the flash crash, despite volatility quickly dropping back to its pre-crash levels, correlation defied gravity, rising to a high of 74 percent in August. High realized correlations are important to investors-it is a way of saying that we are in a market where companies' stocks are not rewarded for good earnings or punished for bad results. Since May, stocks have moved in tandem like a school of fish--when one turns, they all turn.

The new stockquarium is causing frustration among traditional stock pickers. In September, the Wall Street Journal ran an article called "Macro Forces in Market Confound Stock Pickers" noting that the high measure of correlation was making stock picking "feel like an exercise in futility." As one long-time research analyst quoted in the article put it, "Stock picking is a dead art form." Picking individual stocks in a high-correlation environment is like betting on one fish within the school to race another to a distant finish. You know in advance that the entire school will get there at about the same time, so why bother?