Algorithm Causes Oil-Trading Mayhem

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"Your worst fears about high-frequency trading confirmed. . ."

A high-frequency trading firm based in Chicago is being investigated by the CME Group because back in February, it turned on an algorithm that, in just five seconds, caused oil prices to jump up $1, says Reuters.

Get ready to have your worst fears about high-frequency trading confirmed, because here's a story about how an algo gone wild flooded the oil market with orders, "choked," died, and caused a huge spike followed by an even bigger drop in the oil market.

Five seconds after the firm turned it on, they had to turn it off. The algo "choked," after it had already flooded the oil market with orders that made up 4% of average daily trading volume in the contract, and caused a brief 1.3% jump in oil prices, from $76.60 to $77.60.

The firm turned on the algo on February 3rd 2010 just before close. The following day, perhaps because the orders were unexplained, there was a 5% plunge in oil prices. And the day after that, crude fell further, to $71 a barrel, and volume touched a then-record high.

Reuters says the firm has been hugely cooperative with the investigation and actually brought the faulty trades to the attention of the CME Group as soon as they occurred.

This case is fascinating because the faulty algo's strategy is explained in detail. Firms are very secretive about what strategies their algos are designed to execute. So we're lucky to witness an open investigation like this in which an algo is dissected.

It looks like Reuters got to review tons of documents that detail how the algo was intended to work, what caused it to "choke," and the huge effect the algo made on the oil market in just one day.

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