Stock market shock explainedPhysicists
model recent trading frenzy. 1 October
2002
PHILIP BALL
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Some lost hundreds of millions in
September's twenty minute trading frenzy. |
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GettyImages | | |
Two physicists have an explanation for the convulsion of the stock
market just ten days ago that left traders reeling and economists
scratching their heads. The market was behaving like a muffled guitar
string, they suggest, thanks to short-termism and technological
limitations.
The 20-minute trading frenzy on Friday 20 September saw one bank loose
£100 million while another dealer racked up £1 million profit in three
minutes. More shares changed hands than are often traded in an entire day.
It began at around 10.10 am; by 10.15 the FTSE 100 index - a barometer
of the market's overall health - had soared from around 3,860 to 4,060.
Minutes later it plummeted to 3,755 before eventually levelling off close
to its starting point.
Economists struggle to understand these rare, earthquake-like anomalies
that they dub, rather vaguely, turbulence. But to Sorin Solomon and Lev
Muchnik of the Hebrew University of Jerusalem, Israel the event of 20
September looks more like another physical phenomenon: damped
oscillation.
Solomon and Muchnik have built a computer program that simulates
trader-trader interactions for a wide range of different trader
strategies; the model borrows ideas from the physics of colliding gas
particles. They searched for a set of simple 'psychological' rules that
would produce the spike seen on the 20 September.
The model generates damped oscillations if there are three types of
traders: random traders, who buy and sell at small random deviations from
the current market price, market-maker traders who occasionally induce
large price fluctuations, and inertial traders who base their orders on
what they did in the previous transaction.
All the traders are opportunists. "They are interested in short-term
profits and anxious not to miss a trend," says Solomon. If everyone else
is buying, they'll tend to buy too, leading to herding behaviour that
amplifies small price fluctuations into big ones.
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Traders anxious not to miss a
trend can cause these oscillations. |
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S.Solomon | | |
If prices drift too far from what the traders believe is their
fundamental value, they'll slow down and eventually reverse their
behaviour. This makes the prices oscillate around their fundamental value.
But another process damps out these oscillations: a kind of friction
produced by the way traders follow the market rather sluggishly. In the 20
September event, it seems that technological limits on how fast a
transaction can be made may have slowed the market's response.
Explanations like this might not be unique, but by being based on the
behaviour of the market as a whole they contrast with the way that
economists typically seek to pin anomalies on specific causes. Some have
blamed the 20 September turmoil on trading errors made by the Swiss-owned
Credit Suisse First Boston and by Deutsche Bank.
A similar frenzy last year was traced to a deal by a trader for the
US-based Lehman Brothers that was 100 times bigger than he'd intended. But
single errors can't swing the whole market. That happens when other
traders react - the effects of which conventional economic models fail to
predict. |