Path: utzoo!mnetor!uunet!seismo!sundc!pitstop!sun!decwrl!hplabs!hplabsz!taylor
From: kurt@tc.FLUKE.COM (Kurt Guntheroth)
Newsgroups: comp.society
Subject: Re: Computers and the Stock Exchange
Message-ID: <1587@hplabsz.HPL.HP.COM>
Date: 19 Feb 88 01:13:19 GMT
Sender: taylor@hplabsz.HPL.HP.COM
Organization: John Fluke Mfg. Co., Inc., Everett, WA
Lines: 45
Approved: taylor@hplabs

Frank Adams writes:

    I would like to take this opportunity to combat the myth that program
    trading was responsible for the stock market crash.  The biggest cause
    of the crash...is the practice of..."portfolio insurance".  

Both these names are symptoms of the same problem.  Big institutions can
transact a great deal of business suddenly by trading stocks, options,
futures, and other financial instruments with computers.

The price of a financial instrument (say a share of stock) is based on the
market's perception of the financial health of the underlying company plus
the market's perception of the financial health of the general marketplace.
As this perception changes gradually with time, the price of the share
changes.  At any given moment, shares of a stock go for a particular price,
and the market makers keep an inventory of that stock to sell at that price.
When orders come in at a reasonable rate, for individual stocks, this all
works pretty well.

When a computer trade dumps a whole bunch of stocks on the market, individual
market makers don't see the entire trade right away.  Even though the
emergence of a bunch of shares for sale indicate a change in the perception
of the marketplace, this information is hidden from the individual market
makers, who buy up shares of stock AT THE PRE-PROGRAM PRICE.  Within a few
minutes, the traders notice the sudden increase in selling volume and
decline in broad indices.  By then it is too late.  Shares have already
changed hands at "too high" a price.  Of course the human-assisted part of
the program is to set the trade in motion when things are busy, or when a
period of upward motion will mask the program trade's effect for awhile.

What has happened is that the trading system is too efficient.  The trading
system runs faster than the trader's ability to keep up with the trades and
set prices accordingly.  This imbalance in the system causes a sort of
ringing; faster-and-higher-than-expected rises and falls in price.  If the
system becomes unstable, you get 500 point down days.

Eliminating program trading practices, whether it is program stock
transactions or futures transactions would partially rebalance the system.
Slowing order entry would slow the system down to the point where the human
market makers could set the price effectively.  People who say program
trading is the cause of the crash probably are misinformed as to the
nomenclature, but I think they are right that it is the computerized trading
system that permits the disaster to happen.

Kurt