Who Made Money Yesterday During the Dow’s Swan Dive? Smart Futures Traders - UPDATED
Ivy Schmerken published a nice overview piece on yesterday’s market dislocation on the Wall Street & Technology Blog. A little background for those who have not been following the discussion:
As most of us know, problems began around 2 p.m. when the Dow Jones
Industrial Average was already down 200 points –- in part a reaction to the
sell-off in Chinese stocks, translated into concerns about the U.S. economy. I
was in the car at 2:30 p.m. when CBS
Radio reported that the market was crashing and the Dow was down 250 points.The heavy sell-off in U.S. stocks caused a 70-minute lag in correctly
calculating the value of the Dow Jones Industrial Average, according to Dow Jones
Indexes, which issued a statement today.In the release, Michael Petronella, president of Dow Jones Indexes, said the
problem arose in the system responsible for feeding market data into the
calculation system.Recognizing the problem, Dow Jones Indexes switched to a back-up market data
system for calculating the index, which immediately caused the index to drop by
another 200 points at around 3 p.m. -– so the market was down over 500
points.The switch over to the back-up systems caused all the prices to be processed
at once, and this led to the downward spike in the reported index value,
according to the release. When the Dow Jones index was adjusted to the true
value and the market plummeted 200 points, this probably triggered algorithmic
trading programs to generate buy and sell orders, which were concentrated in the
Dow 30 stocks, rather than dispersed throughout the market, the source
conjectures.
Ok, this makes sense. I don’t know, maybe it makes you think that that Grasso guy wasn’t so bad after all, but no matter. Bottom line - we had a little meltdown, the cash market systems couldn’t keep up with the order flow and, therefore, the DJIA gapped down hard after the flood gates were opened. But what happened in between? Was there anyone, anywhere that could have made money from this debacle?
Of course. The answer: smart futures traders.
Please take a look at the chart below.
See the black line - that’s the spot DJIA. See the blue line - that’s the March DJH07 futures contract traded on the CBOT. So, let’s walk through this together. In the morning the spot and futures markets pretty much tracked each other. Then look what happened - uh oh, the spot market is falling behind, while the futures market is reflecting the true market sentiment. They are starting to diverge, then wider, wider still, FOR ABOUT TWO HOURS, until BANG - the alternative cash system kicks in and the flood of sell orders drops the spot index like a stone. So this technical “glitch” was really, at its core, a timing delay. Then the futures market, as if it knew what was going to happen, ran up, after which the spot market followed with a significant lag. After a little sputtering and some continued dislocation late in the day yesterday, they tracking each other once again today. Whew.
So what does this mean? A savvy futures trader that saw the divergence could have positioned themselves to profit from the inevitable meltdown in the spot market, and the subsequent run-up after the futures rallied ahead of the spot market. AND HAD ABOUT TWO HOURS TO DO IT. It is pretty rare to find these profit opportunities in the real world, but they manifest themselves yesterday during the wild ride in the U.S. afternoon trading session.
Anyway, I generally don’t write much about this stuff but felt compelled to share this after knocking around some thoughts with a couple of my colleagues. Interesting day, to be sure. Thanks to Eli for this thoughtful contributions and the chart. Enjoy.
ADDENDUM
In the wake of comments received by readers of this blog, I was made aware that there is an error in my chart - the plotting of the CBOT futures contract is not adjusted to take into account the NY/CHI time difference. First, thanks to those who commented. This is exactly what makes the blogosphere great. I’m usually the one imparting the checks-and-balances, but today I am the recipient of such!
All that said, I’d like to factually explain why the error occurred, and then to migrate to why I believe an arbitrage opportunity did exist, even after correcting for the time mistake. The only substantive difference in the analysis is that instead of a trader manually being able to enjoy the arbitrage profits that were available, the money was invariably captured by stat arbs whose programs picked up on the difference between the the spot DJIA (or the DJIA components individually or in ETF form via DIA) and the theotretical DJIA (as expressed through the CBOT futures). And I respectfully disagree with both Maoxian and my two commenters that arbitrage opportunities didn’t exist, because they clearly did. My charting mea culpa and evidence of the availability of arbitrage profits follow.
Why the Error?
The chart from my post was taken from OptionsXpress, which uses Prophet.net for their charting application. Apparently, when comparing two instruments, Prophet.net does not adjust for time discrepancies, which means that clearly OptionsXpress doesn’t, either.
From Prophet.net
From OptionsXpress
It also appears to be the case that Yahoo!’s new Beta charting application may also give rise to the same error:
These errors, not surprisingly, are not present when one undertakes the same charting exercise on Bloomberg:
So, for those who expect (as you should) factual correctness in all that I write I apologize. I am both embarrassed and humbled by this error. I’ll work hard to ensure that it doesn’t happen again.
The Argument for the Availability of Arbitrage Profits
Let me start with presenting a more granular decomposition of the Bloomberg data above, by importing the data into Excel and plotting the price movements in five minute time increments:
Ok, so do you see the divergence between the spot and the futures? It is not two hours, as I had mentioned orginally, but the divergence is in place for around an hour (which makes sense given the NY/CHI time difference). I’d like to use Chairman Mao’s post as a vehicle for arguing my point that arbitrage profits did in fact exist:
Everyone knows about the Dow Jones Industrial Average calculation glitch
during Tuesday’s slide. Here are a couple overlay charts: 1) the Dow futures
with the DJIA, and 2) the Diamonds ETF with the DJIA. You can see that both the
futures and the ETF were tracking the Dow component stocks correctly the whole
time. There were no opportunities for arbitrage.
Well, I don’t really agree. He is using candlestick charts, which are not sufficiently granular to observe the arbitrage opportunity in question. So no, you can’t “see that both the
futures and the ETF were tracking the Dow component stocks correctly the whole
time.” Because they weren’t and I think that point is pretty widely acknowledged. He continues on to say:
I don’t even watch indexes on a quote sheet anymore (who watches the DJIA
intraday anyway?), but I do follow all the ETFs based on major indexes closely.
I can trade the DIA; I can’t trade the DJIA.
Ah, this is the point. I find the chart comparing the DIA and the DJIA to be a red herring. One is simply the decomposition of the other. They should track each other, by definition. This is not the case with futures and cash, where divergences occur for a wide range of reasons, including technical glitches. But the comment that was the most telling: “I can trade the DIA; I can’t trade the DJIA.” You may not be able to, Chairman, but stat arbs can and do, often thousands of times a day. How could a stat arb have made money? By their programs detecting the divergence between DJIA “real” (the average of the prints of the components that make up the DJIA) and the DJIA “theoretical” (the CBOT futures), executing program sells of DJIA-replicated single-stock baskets across any number of ECNs and simultaneous buys of the futures. While the stock trades wouldn’t have printed due to the glitch, they would have been filled and settled after the backlog had been cleared in the 2:50-3:00PM time frame. Therefore, a stat arb who had sold the cash “rich” and bought the futures “cheap” could have captured the area between the two curves, ex-transactions costs. Not a bad return for a few CPUs.
I’ve read a lot of pretty virulent talk about how arbitrage conditions didn’t exist. My charting error notwithstanding, I don’t agree. And I think the facts - real as they are - are pretty compelling. But that is just my two cents. I’ll leave it to the experts (those who write this stuff and pull down charts every day) to tell me otherwise.
