Knight Capital and its algorithmic trading snafu

Knight Capital

Though not particularly well known to individual–and even some professional–investors, Knight Capital is a very large market-making and trading broker in the US equity market.

algorithmic trading

Algorithmic traders, or “algos,” are typically IT-savvy arbitrageurs.  Like any other arb firms, their business is finding and exploiting differences in the pricing of identical, or very similar, instruments.  Algos differ from traditional arbitrageurs in that they use computer programs to do their searching for them.  That way they can cover more ground than humans, potentially trading more quickly and spotting more opportunities. Computers also execute their trades.

On Wednesday morning, Knight Capital was running for the first time an algorithmic trading program it had apparently developed itself.  The story isn’t 100% clear, but it sounds to me as if Knight was hoping to create an algo service that could be used by individual investors.  In any event, Knight’s computers started churning out buy orders for about 150 stocks at the opening bell.  But the quantities being asked for were huge–much larger than Knight had intended.  And some of the stocks in the bundle were, well, weird.

One of the more offbeat selections was Wizzard Software (WSE).

The issue had closed on July 31st at a stock price of $3,50, on volume of 15,067 shares.  Wizzard provides home health care staff in the West, resells podcasting services from ATT and Verizon, and, yes, it apparently also develops corporate software.  In 2011 WZE had total revenue of about $6.5 million, and lost money.

From the chart I looked at, Knight’s initial order for WZE seems to have been for an astoundingly large 150,000 shares.  That’s a bit less than 2% of the company.  It’s also at least two weeks’ total trading volume. (My guess is that it would take several months to accumulate that amount, if you wanted to do so without moving the price much.  And then, of course, absent a sharp reversal of WZE’s fortunes, you’d have much greater difficulty getting back out.)

It reportedly took Knight almost an hour to figure out that something had gone wrong with its software.  Rival market makers were much quicker off the mark and were providing boatloads of stock to Knight at ever-rising prices.  When the music finally stopped, WZE was close to $12.  WZE was one of six stocks where erroneous trades were cancelled b market officials.

But that left around 146 issues where the Knight orders weren’t simply torn up.  The firm accidentally owned massive (for it) amounts of t=stock it didn’t want.  Once it realized what was going on, Knight cancelled any remaining buy orders and began dumping out the stock it had just acquired.  The company estimates it lost $440 million Wednesday because of the software glitch!!! (To be clear, I think Knight made the correct decision in selling immediately.  The gaffe was too big and too public for it to hope it might trade out of its positions slowly and quietly.)

press comment misguided

Most of the press stories about this incident have revolved around the idea that computerized trading is undermining the confidence of traditional long-only investors, especially individuals, in the integrity of the stock market and the desirability of holding equities for the long term.  I think the stories are  crazy.

For one thing, the S&P 500 only rose about five points in early trading on Wednesday–and then went sideways for most of the day.  If you weren’t a day trader, it may well be that the first you heard of the Knight Capital fiasco was on the news Wednesday night.  Or it might have been the paper on Thursday morning.

The real story?

Consider what has happened to Knight because of its foray into algo trading.

–Its stock has lost about three-quarters of its market value in just the past two trading days.

–The Financial Times reports that major clients have shifted orders to other market makers–Vanguard, e-Trade and TD Ameritrade among them.  Brokers did this initially at Knight’s request.  Clients are remaining mum for now.  Certainly, no one I’m aware of is saying the crisis is over and they’ve gone back to business-as-usual with Knight.  The silence on this score suggests clients think Knight may be badly enough wounded that counterparty risk is a concern.

–According to the FT, Knight has hired an investment banker to help it consider its options, including a merger or sale of the firm.

In other words, it’s conceivable that the management that built the company may soon no longer be in control of it.

I can’t imagine this snafu makes anyone more eager to get involved in algorithmic trading.  Quite the opposite.  The Knight experience may become the cautionary tale that prevents the spread of algo trading away from specialists and into the mainstream of equity trading.