- 2001: Volume 10, No. 1 The Trading Halt Hypocrisy

Experience in a down market? Hardly. The average mutual fund manager was in high school when the stock market crashed… I mean really crashed, back in October of 1987.

That fateful event, which saw the Dow Jones Industrials fall 20 percent in one day, illustrated a few key concepts. First, people understood that a market event was not necessarily an economic event. Unlike 1929, the collapse did not portend a major economic rut or recession. In fact, the market’s subsequent recovery to new highs by July 1989 was among history’s most swift.

What also distinguished the ‘87 crash was the use of stock index futures, whose role in accelerating the decline is still hotly debated. Some industry professionals, along with the federal government, found cause to believe these highly leveraged contracts created a panic sell-off of disproportionate velocity.

While others dispute these findings, there is little doubt that the use of "portfolio insurance" strategies, which were nothing more than resting stop orders to sell S&P 500 futures at various percentage downturns, were a factor in creating the horrendous opening on October 19, or what we now call "Black Monday."

The Chicago exchanges, eager to prevent further negative publicity, acted to impose a system of trading halts on their contracts in 1989 so that further debacles could not be laid at their doorsteps. These included opening limits—originally 5.00 S&P index points—a trading halt at 12.00 points, and a balance-of-day halt at 30.00 index points. These were in addition to a New York Stock Exchange shutdown of its Super DOT (Direct Order Turnaround) computer system used by program traders to execute stock baskets automatically whenever the Dow Jones Industrial Average moved 50 points in either direction.

"People came out of 1987 thinking that perhaps the market needs more time to react to a news event" says Rick Redding, director of index products at the Chicago Mercantile Exchange. "The halts provide a chance for people to step back and ask themselves ‘do I want to do this?’"

These limits have been modified over the years and some have been eliminated altogether.

If you look at the statistics, however, it is clear that trading halts, limits and interruptions of any kind are an unnatural disturbance to the markets. Halts make the market systematically less efficient, more volatile and unstable—just the conditions the halts were designed to correct.

The short-term traders who buys and sells frequently should take extra caution around trading halts. Long-term investors might want to lobby their legislators to get rid of them altogether.

Why? Well, quite simply, I strongly believe that it is the trading limits and halts themselves that create volatility. If you wish to create panic buying and massive shortcovering, just create an upside limit. Professional traders will keep triggering upside stop orders, and short sellers will cover in fear of being squeezed themselves. Consequently, downside halts are just as dangerous. They drain market stabilizing liquidity by creating an unnatural disincentive to add liquidity—namely the fear of buying a market soon to be "limit down." Why take a position if the market is in danger of being disrupted or even shut down?

The danger of trading halts was most recently illustrated on October 27, 1997, when trading on the NYSE was closed for the day as the Dow plunged some 550 points, its daily limit. For the first time in history, both the New York Stock Exchange and the Chicago Mercantile Exchange (where S&P 500 futures are traded) both ended business for the balance of the day due to a limit being reached. (See Table 1.)

Table 1

Chronology of Oct 27, 1997
Time	Limit Reached	Duration
10:14 10:24 10:26 12:20 12:30 1:35 1:36 2:07 2:24 2:30 2:30	15 pt initial daily limit offer Trading halt Trading resumes 30 pt intermediate daily limit offer No halt, 45 pt limit in effect NYSE halt due to 350 pt decline in DJIA 45 pt daily limit offer - Trading halt Trading resumes (DJIA 50% cap reached) 70 pt daily limit offer NYSE reaches 550 DJIA limit - trading halt NYSE closes for the day - S&P closes for the day	2 minutes

While we cannot run a controlled experiment to see how the market would have traded in the absence of limits, it is worth mentioning that many traders felt the limits hastened and exacerbated the day’s final plunge. Why? Professional traders stabilize the markets by adding liquidity—buying when nobody else wants to. Again, why take a chance in buying when the exchange itself was on the verge of being closed?

Since there is no way to definitively prove how markets would trade in the absence of halts, we can alternatively examine the effect trading halts have on the market overall. So instead of asking where the market would trade in a halt-free world, I instead examined how the market would trade without this unnatural disruption.

To begin, we’ve got to get a sense of what a "normal" or "average" day looks like for the market. Over the life of the S&P futures contract, 4,677 trading days, the market has had an average daily return of 0.532 percent with a daily standard deviation of return of 1.209 percent. Standard deviation simply means that on the average day, the market tends to have a total fluctuation of approximately 1.2 percent from its highest intra-day high and lowest intraday low.

On the days when trading halts of any kind occurred, the average daily return was -1.364 percent with a standard deviation of return of 2.303 percent, which gives us almost total certainty that trading halt days are statistically different from the general population. What is surprising, however, is that after a day in which trading halts are triggered, the market remains at statistically abnormal levels for a period of approximately five trading days. During this period the market generally exhibits higher then average volatility coupled with below average returns. (See Table 2.)

Table 2

Impact of Trading Halts
Days After Halt	Average Return	Standard Deviation of Return
1 2 3 4 5 "Normal" day	-0.0312% -0.0378% 0.0367% 0.0156% 0.0502% 0.0532%	1.976% 1.938% 1.666% 1.958% 1.431% 1.209%

So rather then stop panic, trading halts actually increase it—for five straight days.

Even worse, the halts offer the false premise of safety. Oftentimes, the market falls and is halted, only to rally once again after the halt is lifted. This has prompted many people to believe that, because of the halts, the stock market could never crash. While that can be true, the market is going to go where it goes. Unless you have the courage to sell losing positions, a prolonged downturn in prices can be even worse than a crash. The market trends down… but because of the five-day "shock" effect of the halts, one could suggest that moves that would have perhaps taken a day or two are perhaps lengthened to weeks or even more. At best it robs you of the time value of your money. At worse, you double down on false hope and buy more.

Savvy floor traders usually get long after halts and play the dead-cat bounce. Investors, however, who might not even be aware the halts and limits have been utilized (especially when futures halts are triggered) are given the false impression that the market is more stable then it really is.

The entire purpose of a market is to allow buyers and sellers to discover prices and transfer risk. Any interference in this process will confer a temporary and unnatural benefit on one relative to the other. Who is hurt most is the individual investor. When halted markets re-open, the usually do so at the most disadvantageous prices for the little guy with just a few hundred shares.

What’s worse, however, is how a closure increases the risks of participation for all parties involved, both directly and indirectly. If buyers and sellers are precluded from transacting, this must mean a loss of information to the system as a whole, a loss of efficiency, and an overall loss of economic welfare.

Market closures may send the unwanted signal that this game is in fact safer than it actually is, and that’s a major social cost. Unless we can demonstrate, conclusively, any benefit to closing a market then we should end this pointless exercise and get back to work.

Jonathan Hoenig (capitalistpig.com) is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund. Hoenig’s first book, Greed is Good: The Capitalistpig Guide to Investing was recently published by HarperCollins. Hoenig is a frequent commentator in the financial press, and has written for publications including Stocks and Commodities, Parade, Maxim, Wired, TheStreet.com, Hightimes and Green. He has spoken in front of schools across the country, and has been featured in numerous publications including The Wall Street Journal, Institutional Investor and The Chronicle of Higher Education. Jonathan was recently named one of The Chicago Sun-Times’ "Thirty Under Thirty" and Crain’s "Forty Under Forty." He is a member of the Economics Club of Chicago.