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JPMorgan’s Algorithmic Market Crash Analysis Was Brilliant But Flawed

Marko Kolanovic, Ph.D., the Global Head, Derivative and Quantitative Strategies at JPMorgan, had an eventful week. It started last Friday with probably one of the more insightful and useful research notes pointing out performance drivers associated with Monday’s “limit down” open to the stock market. This wasn’t just among Kolanovic’s best, but, it could be argued, it was among the most insightful research to come out of JPMorgan, who has a respected team of global researchers known for strong research. Later Kolanovic followed up his success by warning of more potential market volatility to come.

In this analysis, "CTA trend following" strategies are assigned anywhere from 66 to 33 percent of the blame for their short exposure to equities. This is based on Kolanovic's assumption that CTAs have $100 billion in total trend following equity exposure. This analysis misses on several levels, but most significantly is that it did not accurately categorize the impact of Bridgewater Associates and its strategy on CTA assets under management.

JPMorgan attempts to determine who is to blame for the recent market volatility? China, Fed tightening concerns or CTA trend followers?

A key point of Kolanovic's work becomes clear rather quickly. The report appears to be looking for those to blame for the stock market collapse other than fundamental reasons, namely China and the U.S. Fed raising interest rates. The insightful light that Kolanovic shined on the market was technical, not fundamental as he categorized "price insensitive sellers" into one gang:

A good example of how price insensitive sellers can cause market a disruption/crash is the price action on the US Monday open. We believe that technical selling related to various hedging programs, in an environment of low (pre-market) liquidity indeed caused a ‘flash crash’ on Monday’s open. S&P 500 futures hit a 5% limit down pre-open, and then a 7% limit low at 9:31 and 9:33. The inability of hedgers to short futures spilled over into large cap stocks that were still trading and could be used as a proxy hedge. Had it not been for the futures limit down event, the selloff would likely have been worse as indicated by the price of the index implied by individual stocks.

It is this piece that, while insightful on the whole, might warrant closer inspection of certain components to determine their validity. On August 21, Kolanovic accurately calculated the pressure that certain derivatives traders had placed on the market, correctly predicting the option gamma hedging imbalance, creating selling pressure into Friday’s close which led to Monday’s limit down open, as first reported in ZeroHedge. This is arguably exceptional research work. However, why did't the sum total of his report consider the impact of high frequency trading to any significant degree?

Yesterday Kolanovic followed this research feat with perhaps a more tenuous report. In “Technical Selling – How Low Can It Push Equities,” Kolanovic predicted another stock market rout was in the offing and pointed to four primary factors: derivatives hedgers, trend following strategies executed by CTAs, risk parity portfolios and volatility managed strategies. High frequency trading was not considered.

Kolanovic may be correct on his prediction more selling is on the way, that is yet to be seen. But his assertions regarding trend following CTAs being the majority or even implications that CTAs a high percentage of the cause the past or future market volatility has drawn sharp questioning. While hints that CTAs were involved involved in short-term, intraday trading have drawn sharp criticism, Kolanovic’s claim that CTAs represent can represent $100 billion in short equity exposure is perhaps the most significant assertion that is worthy of consideration as it points to future responsibility.

Are CTAs engaged in short-term, intraday trading?

In apparently placing blame for the recent market volatility on “technical factors,” or algorithmic trading in general, Kolanovic might be accurate to various degrees. But the implication, or even a distant thought, that the initial impetus, or trigger, for the current market volatility was anything but fundamental is laughable in some quarters. “What a relief. Glad that the decline in China was not the cause” for the recent market volatility, quipped Sol Waksman, president and owner of BarclayHedge. BarclayHedge is the leading database that monitors CTA and hedge fund performance metrics, including assets under management, and is not to be confused with Barclays Bank.

Waksman agreed that even a slight inference that CTAs were somehow a cause of the market volatility by trading on an intraday basis was unlikely. A quick search of the CTA database at shows that of the close to 1,000 CTA funds that reside in the database, there are only 5 listed with “equity short bias” or “dedicated short” exposure.

There are many reasons why only small numbers of CTAs engage in intra trading that mostly due to that trading strategy not being conducive to industry business models. High frequency trading firms, which generally operate on the premise of making a small amount on each trade (small win size) but having a high win percentage, are diametrically opposed to most trend following CTAs which, studies have shown, have a high win size but a lower win percentage. Further, many high frequency trading firms, because they have such a thin profit margin on each trade yet high notional risk exposure, they rely on exchange trading rebates to lower their trading costs. It might be concluded that high frequency trading firms don’t want the National Futures Association, the generally tough CTA industry regulator, to audit HFT business operations and performance as they do to CTAs, who generally find such experiences unpleasant.

While the JPMorgan report did identify that most trend following CTA strategies take execution signals on a weekly and monthly basis, even the slightest suggestion that short-term CTAs were somehow linked to...