Nanex Research

Nanex ~ 20-Aug-2013 ~ Rogue Algo Exposes Cracks in Options Market

Update: July 6, 2015.

On June 30, 2015, the SEC announced they had charged Goldman Sachs with violating market access rules and fined the firm $7 million for causing the disruption outlined below.

Reading the SEC order, we came across a few eye-opening statements. First, Goldman only computed their market exposure every 30 minutes. As any reader of our site knows, a lot can happen in  30 minutes. The flash crash lasted less than half that time.

The next revelation, was the magnitude of Goldman's loss: after just a few minutes of trading, it amounted to a staggering $500 million. Even more disturbing - Goldman was able to cancel many orders and get price adjustments (price adjustments?) after the fact, which whittled their loss to $38 million. We wonder how the counterprties to those trades felt about effectively giving Goldman back $462 million. Since these were options trades, many of counterparties would have likely hedged those trades with stock, leaving them exposed after finding the option leg was taken away. There is something very disturbing about a firm with direct market access being able to cancel/adjust their losing trades after the fact.

Given the magnitude of the loss and take-back ($462 million), we think $7 million is far too low of a fine. Perhaps $7 million plus restitution for the counterparties would be more appropriate, and provide an economic incentive for firms with direct market access to be more proactive in preventing errors like these. The root problem that caused this event was simple neglect to include basic software checks, probably because there's no economic benefit to doing so. And why would there be, when Goldman can simply call up the exchanges and have their mistakes canceled. Not exactly capitalism. Nor confidence inspiring for counterparties in the future.

Update: September 11, 2013.

Looking closer at the data from the AMEX options exchange just before it went offline (chart 9 below), we find a series of quote blasts starting at 9:36:33.979 and continuing until the exchange went dark at 9:36:37.551. These messages are comprised of quotes with zero bids and asks which are used to clear out an exchange's quotes from downstream systems (quote terminals and the like), and maintain the integrity of the NBBO. The presence of these messages indicates that this was a planned, orderly shutdown.

Did AMEX prevent a repeat of the Knight Capital Meltdown by pulling the plug?

We have to wonder: did the firm that ran the rogue algo ask AMEX to shut down because they couldn't figure out what was wrong or how to shut the algo off themselves? Or was the exchange being proactive and shutting down just in case they had another Knight Capital like meltdown on their hands? Is this the first known use of a kill switch? A bit overkill (only one firm needed to be killed, not the entire exchange), but given Wall Streets recent technology failures, this was a prudent decision.

Original Text.

Shortly after market open (9:30 ET) on August 20, 2013, a rogue High Frequency Trading (HFT) algo appeared in the U.S. options market and began affecting both options and stocks. The algo placed orders to sell up to 1000 option contracts on stocks with symbols beginning with the letters IE through KIM. The sell orders were placed on the AMEX options exchange with a limit price that started out high, and over the next minute, ratcheted down one penny (or minimum price increment) at a time to $1: regardless of the strike or value of the underlying stock or ETF. The sell order sizes started at 1000 contracts and only decreased when buy orders executed against them. The algo didn't appear to take into account higher bid prices on the other options exchanges - because when it lowered the sell price, it often caused the NBBO (National Best Bid/Offer) to lock (bid = ask) or cross (bid > ask).

As soon as option quotes in the affected symbols began exceeding theoretic economic values by some threshold, quotes (and therefore liquidity) on other options exchanges for those contracts would immediately disappear - bid/ask prices would go to zero at other exchanges.

Within 10 seconds of starting, one algo, in effect, completely destroyed the concept of the National Market System and obliterated liquidity.

At 9:36:37.551, options quotes ceased from the AMEX exchange in all options, not just those affected by the algo. Maybe the firm responsible for the algo thought it was AMEX's fault, or maybe AMEX noticed a large number of crossed option quotes and took action. Regardless of the cause, the outage lasted 13 minutes.

It was later reported that the algo was run by Goldman Sachs. What was the fine for shutting down an options exchange, and destroying liquidity in hundreds if not thousands of options contracts?

There was no fine. Worse, they were able to get the trades busted.

As in, pretend we didn't just do that. Pretty shocking.

Until there are financial consequences for firms that turn on market disrupting algos, the markets, will continue to be distrupted.

List of several, large, well known symbols with a significant aberration in option prices:

Symbol Name Market Cap ($Billions)
IWM Russell 2000 ETF (Assets) 25
JPM JP Morgan 200
IMO Imperial Oil 36
K Kellogg 22
KIM Kimco Realty 8
JOY Joy Global 6
JLL Jones Lang Lasalle 4
IT Garnter 5
IEX IDEX 5
KBR KBR 5
JOE The St. Joe Company 2
1. All IWM Options Contracts: Ask prices color coded by reporting exchange. Chart shows about 5 minutes of trading.
Multiple lines of gold triangles representing ask prices from AMEX descend towards $1: these are from the rogue algo. The triangles form lines: one line for each option contract the algo was selling.
2. IWM September 2013 96 Call - Showing all bid and ask prices color coded by exchange and NBBO over about 2 minutes of trading.
Note the line of gold triangles descending towards $1. These are ask prices from the rogue algo. It is one of the strings of gold triangles from Chart 1 above.
3. IWM September 2013 96 Call - Showing trades and NBBO.
The large gold dot is from one trade of 933 contracts.
4. IWM September 2013 96 Call - Showing best bid and ask prices color coded by exchange and NBBO. 
5. IWM September 2013 96 Call - Showing best bid and ask prices color coded by exchange and NBBO. Zoomed out in time from Chart 4 above.
 Note how the NBBO spread remained exceptionally wide (over $4) for many minutes after the rogue algo stopped. The spread temporarily narrowed right after the AMEX Options Exchange was halted.
6. Message rates for each of the 48 multicast lines that carry option data. The bottom panel shows a count of crossed NBBO quotes by multicast line.
Lines 21-24 carry traffic for symbols IE - KLZ and are colored light blue/green. Note these lines show a large number of crossed quotes (very unusual) in the first 6 minutes of trading.
7. Message rates for option quotes and trades color coded by reporting exchange. The spike is from AMEX just before it goes silent (a burst of zeroing out quotes).
8. Showing quote message rates from AMEX. You can clearly see the outage. See Chart 9 (below) for a close up of the spike just before the outage.
9. Close up of quote message rates from AMEX just before shutdown. This is what the red spike in Chart 8 (above) looks like, close up.
These are zeroed quotes (bid/ask are 0) indicating a planned, orderly shutdown, and not a system failure.
10. More Examples.
        

Nanex Research

Inquiries: pr@nanex.net volatility