If you have been staring at the crypto mayhem all day long, it’s time to get back to more traditional asset classes. The US stock market has shown tremendous growth since the start of the year, and the strongest January in 31 years propped up investor confidence to the highest levels in a while.
Today, in a matter of 10 minutes, that confidence evaporated, leaving the market hanging in the air. If you have been wondering why Alpari cut leverage on indices last week, have a look at the stock market today.
— Eric Scott Hunsader (@nanexllc) February 5, 2018
The Dow Jones Industrial Average just had its worst daily point drop ever, after shedding over 1,500 points. Just as the final hour of trading was starting, the leading US index dropped 1000 points in about 10 minutes. As the market is approaching the closing bell, the DJIA is back up about 800 points at the time of writing.
The volatility has caught a number of traders unprepared with the VIX index posting a 100 percent rally at some point. Liquidity was much lower when compared to Friday, which already pressured some brokers. As already mentioned, Alpari was the first retail broker to increase margin requirements on index futures to between about 1:33 and 1:50 on Friday.
Brokers Should to Prepare for Low Liquidity Events
During volatile markets, there are two types of challenges that brokers face. Market makers are looking to optimize their book and protect their exposure to profitable traders, while STP brokers are looking at execution challenges related to the order execution process.
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While market makers are making their margins on clients betting on the wrong side of the market, STP brokers are facing counter-party risks if the stop-loss orders of their clients are not executed at the appropriate preset level. Such challenges are particularly relevant for index futures markets, where unlike the 24/5 operation of the FX market, the underlying markets are closed for most of the day.
Commenting on the latest market moves to Finance Magnates, the Head of Trading of TradeTech Alpha, Kurt Hoeksema, said: “Volatile markets highlight the need for a consistent and scalable risk management tools. Being aware of these events in real-time and having systems in place to handle this type of volatility is key to the success of a broker.”
“Underlying market liquidity did dry up for a period of time and this highlights, even more, the need for a proper credit, margin, and execution processes. Preparation and stress testing of these processes are key. You cannot predict these type of situations,” Mr. Hoeksma added.
Pundits point out that the US stock market has been suffering from bad liquidity due to the rise in interest rates. Bond yields traded sharply lower today, signaling that the Fed might rethink its approach to further removing stimulus from the market.
Commenting on the market events of today, the Managing Director IS Risk Analytics, Jeff Wilkins, said: “The market was caught by surprise on this afternoon’s sell off in the equity market. Whilst the dust is still settling on the day, brokers with properly optimized books stand to benefit from the sudden increase in volatility.”
The market continued its tumble after hours, with major US indices shedding between 4 and 5 percent on Monday. The CIO of CB1 Capital, Todd Harrison, summed up today’s market nicely in a single tweet:
Not sure that was a ‘flash crash’ as much as pent-up gravity / complacency but time will tell. The $DJIA retraced 50% of today’s (1600 point) decline but for what it’s worth, *that* felt panicky near today’s lows ($VIX +100%). $SPX $NDX
— Todd Harrison (@todd_harrison) February 5, 2018
Only time will tell if this was an isolated event, but it certainly doesn’t feel like it, not after a relentless 8 year rally of the US stock market.