Headlines or Algorithmic Trading?

After a two-day rally that pushed the S&P futures up 36 handles, the futures contract was both out of gas and overextended. While most will say yesterday's decline was due to Speaker John Boehner's comments that the House of Representatives will push a budget proposal that President Obama has already threatened to veto, that's only part of the story. The other part is algorithmic trading and running buy and sell stops.

Running one of the largest desks in the quadrant taught us some things that affect the S&P futures. One was that after the third or fourth index arbitrage program, the bids or offers could actually play a part in making the index move the opposite way. Let me explain: When a program trader sets up a sell program, he “bids” on the front month S&P. When the levels set up correctly and the S&P futures are  trading at a discount to the S&P cash the program trader would place bids in the big S&P and as soon as I gave him a fill he would quickly sell the cash, locking in a profit on the spread. In order to do a buy program the program trader would “offer” the big S&P futures at a premium over the S&P cash, thus selling the futures and buying the cash. What really made the job easier was when I had both sides of the trade, meaning when a big hedge fund or bank would tell me to sell 1000 or 2000 big S&Ps. I would just pick up the trader at UBS, scream “give me a bid” and he knew exactly what I was doing, I had a big sell order and my sell orders were going to hit his bids, understand? What we noticed after doing thousands of programs was that after the third or fourth sell program, tons of bids would show up, literally clogging up the S&P. After we knocked out two or three sell programs we had the cash moving. As I started to complete my sell order, more bids from other program trading desks would start to enter orders, and more bids would pile up than there were orders for sale. Once this happened you could tell the levels were slipping and with no more sell orders in the outrights, the S&P would automatically short cover. Knowing I started the selloff and knowing the sell order was completed, I knew the S&P would bounce.

I did not have to read any stories in the financial press about why the S&P closed down 0.76%. But I can write a few lines about what the Wall Street Journal or CNBC has to say about why the S&P sold off, because we are the source. You can get it on Fox or Bloomberg, but where do you think they get it? Some retail broker out in Idaho? No, from us, the guys on the floor.

Yesterday's selloff was simple. After two days of going up and 36-plus handles, the S&P futures got stretched out, meaning when the the S&P sells off and people get short they cover and get long. With the ranges as small as they are, the selling pushes the futures down into the sell stops and the short covering / buying pushed the S&P back up into the buy stops. It's what we call the S&P musical chairs. The recent selloff ran the sell stops down below the big figure at 1400 and the most recent rally took out all the buy stops up to 1445.8.

Danny Riley is a 34-year veteran of the trading floor. He has helped run one of the largest S&P desks on the floor of the CME Group since 1985.

Our view: Both side of the aisle are trying to get their points across and neither are listening, and for that the public and the markets are suffering. Right now everything we do on the trading floor is tied to a headline. Yesterday the headlines were bad and today they will be good. As Marty “The Pit Bull” Schwartz used to say, “It's like an old song, take out the buy stops, take out the sell stops.” Well, you know what, Marty? They are still singing that song.  As always, keep an eye on the 10-handle rule and please use stops.

• It's 7 a.m. and the ESH is trading 1432.25, down 0.25; crude is up 2 cents at 90.00; and the euro is flat at 1.3259.
• In Asia, eight of 11 markets closed up or unchanged (Nikkei -1.19%, Hang Seng +0.16%)
• In Europe, six of 12 markets are up (CAC +0.60%, DAX -0.02%)
• Today's headline: “Budget Talks Keep Markets Nervous”
• Economic calendar: Today: GDP, jobless claims, corporate profits, existing home sales, Philadelphia Fed survey, FHFA home price index, leading indicators, Fed balance sheet/money supply, UPS busiest day; earnings from CarMax, ConAgra, Darden Restaurants, Discover Financial, Rite Aid, Nike, RIMM, Micron. FRIDAY: Quadruple witching, personal income & outlays, Chicago Fed activity index, consumer sentiment, BLS state employment stats and earnings from Walgreens
• Fair value: S&P +3.75, NASDAQ +10.5

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