- The NatGas Market Meltdown

This is an interesting story, that's being followed by the gang over at Zerohedge.

(As a convenience,here is the original story which like many at Zero-hedge, is an exercise in the creative use of market graphing tools.)

The author has come to the conclusion that this activity indicates that things are totally F*cked, and I agree. But I think they are misunderstanding the deterministic cause. And the reason for that is that they are forgetting what makes markets work in the first place. The author seems to believe that this is being caused by a single algorithm, which I believe is almost certainly incorrect. I believe it's actually being caused by a collection of algorithms, each acting on a similar set of instructions and failing in aggregate.

In short, if there is no one else trading at that moment (except other algorithms with an equally short outlook) for the systems to trade against, it would cause trading action exactly like this. The slowest of the algos acting (acting independently but on the same very limited instruction set and equally limited inputs) will generate just enough trade activity to cause the others to pull their bid-offer pairs. The slowest system get caught, which will generate more trade activity and cause the others to pull back again, and so on and so on and so on, until a complete lack of activity at the current price level and a retraction of the bid-offer pairs causes the market to find it's natural place - a sell off. At that point more traders are brought into the market, and something resembling normal price stability resumes.

The reason it works this way is that the price stability of a 'normal' market is really an illusion. It only happens because traders with differing investment horizons each are acting independently. While one is a short term seller, another is a longer term buyer, or vice versa.

But as the average holding period of market participants shortens, the difference between trader A and trader B falls... eventually to zero. At high frequencies there are few valid inputs and little room for differing opinions. It's only over the longer term where differences in analysis become apparent and will generate activity as diverse as one seller and a separate buyer.

So when the only players left participating in the market are all worried about the very short term outlook, they are all looking at the same data, and assuming they are acting rationally, they are all coming to very similar (if not identical) conclusions about it.

At that point, they effectively become different components of a single operating entity. But since it's an entity which is looking to exploit the activity of a nonexistent trader with an opinion opposite to theirs, what's left seems to be a deranged entity. It's a snake that lacking other prey is eating its own tail. This is precisely the kind of thing we were seeing in the equity market last summer, and the reason I called QE2 a nominal success. It brought in longer term participation, and that brought with it price stability. Now that’s it’s going away, we should see this more and more in the equity space again.

This can’t go on forever. Eventually it will result in a purge of HF traders. HF is really about technology now rather than intelligence or insight. There isn’t that much to analyze at HF so the math itself, and even the software is pretty straight forward. It’s like a drag race with no rules on the specifications for the car. The person who spends the most money wins every time.

But between here and there is a lot of pain for everyone. Especially the HF snake.