Protection During a Liquidity Crisis like the Flash Crash
The majority of my strategies use market orders. I worry about these strats for when the inevitable next liquidity crisis (a la the flash crash) presents itself. There are horrific stories of people sending mkt orders and getting filled on large cap stocks and very liquid ETFs at prices 90% below their previous day's close.
I am thinking of ways I can protect myself from an event like this for the strats using market orders.
My first thought it is change all the mkt orders in these strats to limit orders with a wide limit threshold. I hand pick the equities I trade based on their extreme liquidity so for the vast majority of the time I would never expect the limits to be needed. The idea would be to run a test strat using limit orders (with very wide limits) next to a mirror strat that uses mkt orders only to see if I receive the same fills during periods of normal liquidity/volatility.
For an example, let’s say the limit tolerance is 3%.
Now, my syntax may not be correct, but this is how I am envisioning it:
Currently I say:
Buy next bar at mkt or,
Sell(short) next bar at mkt
With this new version I would say:
Buy next bar at close * (1+ (Limit_Tolerance/100)) limit or,
Sell next bar at (close * (1- (Limit_Tolerance/100)) limit
Or, I could add a conditions that says if the bid/ask spread is greater than X, then use limit order, else use mkt orders.
Is there is a better way to accomplish my objective of protecting against catastrophic fills during a liquidity crisis?
Would appreciate any ideas or suggestions.
Thanks in advance!
If you trade a limited number of instruments you could use an options Strangle to protect from catastrophic slippage.
I trade the 6E futures contract and always want to protect myself from an unexpected event like when they unpegged the Swiss Franc. If you are on the wrong side of the market during an event like that, the slippage could not only wipe out your account but your broker could come after your assets as well.
Using a Strangle you can define the maximum damage or risk you are willing to take.
You buy a Call Option and a Put Option both far out of the money.
Using the 6E for example, if I want to limit my total risk to $15,000, I buy a Call Option $1.2000 above the current strike price and buy a Put Option $1.2000 below the current strike price.
If the market were to jump in either direction, one of the options increases in value and the other decreases but you never lose more than you paid for the options. For the 6E this currently costs about $240 per 3 months quarter per contract. Not bad as an insurance policy as opposed to losing my home.
I use this when trading Crude Oil also but normally just protect it on the upside in case of war in the Middle East. Interestingly, that was one of my best trades when I cashed out my Put Option a few years back. The market jumped over the weekend, I think the event had to do with Israel or Iran at the time.
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My trades are usually under 15 minutes in length on a day trading basis. I prefer the protection of options just in case I am in a trade when lightning strikes. When they unpegged the Swiss Fanc it only took 2 minutes for the market to move over $20K per contract. Ouch!!
Another problem with the flash crash was that the exchanges cancelled trades. Thus, several traders bought on the bounce and sold after a certain profit. The exchanges notified the brokerages of their intention to cancel the trades, unfortunately no-one knew what the timeline was. Thus, someone who came in and supported the market (or got a real bargain depending on your view) and sold as it went in his favour did not know whether he was flat on short. To me that is a rather significant risk.
Don't forget that the progressive and coordinated US circuit breakers (see Price Limit Guide)
have been introduced only in the aftermath of the Flash Crash. So your best benchmark today
are days like August 24th, 2015, when these circuit breakers were triggered.
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I agree with your mistrust, but it's the current (short-term) regime ...
So the best one can do at the moment is check if his/her portfolio would stand this stress test.
(The acid test for the markets could occur when the short-term regime is triggered several
times in a row.)
Riding out days like 8/24 is absolutely impossible for all who are marked to market.
Accordingly 8/24 US volume of derivatives AND cash markets topped any other day of the last 12 months.