in the post mortem analysis of that 1987 crash, one “culprit” was identified: the use of automated trading strategies that were designed to provide “portfolio insurance”. These strategies are designed to gradually reduce a trader’s equity exposure as the market falls, so that his potential loss is limited to a pre-determined amount. (In essence, the strategy uses dynamic trading to replicate the payoff of an option.) The problem, of course, is that when too many people are trying to get out at the same time, the “door” may not be wide enough, causing prices to fall, which then requires those following the strategy to sell even more. This is a key reason why so-called “circuit breakers” were put in place on the New York Stock Exchange [NYSE] and other exchanges, to halt trading temporarily if a suspiciously large price change occurs, to provide time for human intervention.A lot has changed since 1987, and automated trading, particularly very short-term trading strategies known as high-frequency trading, has become a very big business. It is estimated that this trend is largely responsible for the 164% increase in daily trading volume on the NYSE, as well as the rapid proliferation of alternative, computer-based “exchanges”. The time frames used in these strategies are in some cases so short (measured in milliseconds) that firms aggressively bid for computer locations physically close to the exchange’s data center: the network propagation delay (at the speed of light!) has to be taken into account.
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