Today we go live with the new Limit Up-Limit Down (LULD) mechanism that will replace the single stock circuit breakers currently in place. LULD is intended to prevent trades from taking place outside specific price bands. This proposal was proposed April 5th, 2011 – about eleven months after the Flash Crash – and approved by the SEC on May 31st 2012. The exchanges have been coordinating testing and implementation for months now, with tireless work and weekend testing by much of the industry. While nearly universally applauded by the industry as a well-designed protection mechanism in the aftermath of the Flash Crash, it should be known that there are some who believe the LULD mechanism is complex, requiring large data inputs, and would not have even worked during the Flash Crash. Nanex’s Hunsader has even made the case that LULD would have made the Flash Crash worse.
Regardless of all of our collective opinions on LULD, it is our collective reality, and this morning we would like to highlight things you should know about LULD. Here goes.
LULD will be implemented in two phases. Phase I begins today and covers Tier I NMS securities only (S&P500 stocks, Russell 1000 stocks, and some exchange traded products (ETPs). It is in effect between 9:45am and 3:30pm only. Phase II will likely be about six months from now, and should cover the entire trading day – 9:30am – 4:00pm.
The Limit Bands are as follows for Phase I:
Previous Closing Price (PCP) > $3.00 = 5% band around reference price
PCP between $0.75 and $3.00 = 20% band around reference price
PCP < $0.75 = lesser of $0.15 or 75%
The Reference Price is calculated as the arithmetic mean of trades taken place in the previous five minute window.
Limit State is entered when the National Best Offer (NBO) equals the lower limit band, or when the National Best Bid equals the upper limit band.
Limit State is exited when the size of all Limit State quotations are either executed or cancelled within 15 seconds.
If a Limit State is not exited within 15 seconds then the Primary Exchange will declare a five minute trading pause.
A Straddle State occurs when a stock’s NBB is below the lower limit band and the NBO is within the price band, or if the NBO is above to upper band and the NBB is within the price band. If such a Straddle State occurs, the primary exchange may choose to declare a trading pause, or not, depending on whether they feel the trading in the stock is “abnormal”.
It will be important to watch the “re-opening” process as stocks exit from trading pauses. Of course the hope is that these processes all run smoothly, without data backups and slow-downs to other stocks not in the trading pause. For example – if Facebook’s common stock is on the same server as Ford’s common stock, and Facebook stock trading triggers pauses, we hope there will not be spillover to any other stock – Ford in our example. We also hope that a paused stock will reopen easily and without hitches.
We also believe that the exchanges and regulators should be on the lookout for non-normal and manipulative trading activity that might intentionally trigger trading pauses, for whatever reason. For example we hope they would be on the look-out for quote flickering in Ford’s stock while Facebook approaches Limit States.
We also can’t help but wonder if more stocks will “gravitate” towards their 5% LULD bands than they otherwise might have on pre-LULD days.
Finally, while all of our hopes are for a smooth and functional LULD protection mechanism, we know that on “stressed” days, strange things can and do happen. With that in mind, we believe it is important to monitor any stocks we are trading pro-actively, especially ones that have news and price action that might have those stocks trading close to their LULD bands. Perhaps in such cases a high percentage-of-volume (POV) algorithm might not be the wisest execution choice, for example.