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Home Hedging Strategy When Machines Take Control

When Machines Take Control

Today it was reported that Knight Capital had a problem with their trading and market making algorithms which caused the NYSE to review the trades of 148 stocks earlier in the day.  Their review concluded that trades in six stocks would be canceled if they fell outside of a 30% band (either high or low from the day’s open).  Bottom line, a machine ran amok.

Days like today make us feel glad we hedge.  Just as we did on May 6th, 2010…the flash crash.

We didn’t see any problems in the market and in fact our hedging strategy was adding exposure.  We got 60% exposed (80% long and 20% short) on 4/5/2010.  It looked to us according to all our core indicators that this was a rally that might stick.  Then during the week of of April 26th 2010 our market risk indicator flashed.  It closed the week with a Market Risk Warning so on Monday the 3rd our portfolio was fully hedged.  The first few days of the week seemed uneventful and we figured that we’d probably be trading back out of the over the following few weeks.

Then Thursday, May 6th, 2010 came with a huge move down at the open.  Later that day, I was out running some errands and heard on the radio that the DJIA was down over 700 points.  I got on the phone and called a buddy of mine and the first thing he said was, “It’s a terrible day to be long.”.  But it was a great day to be hedged.  On May 7th we took profit from the hedge portion of our portfolio and bought more of the stocks in our long portfolio.  We did the same again on 6/28.

Just like we were during the flash crash we were comforted today even though things weren’t right with a market maker…our hedges would have protected us.

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