May 17, 2010
There are two existing regulatory policies which may be creating or exacerbating periods of extreme volatility, as were experienced recently.
1. When a trade is broken, the counterparty to the broken trade can be exposed to extreme risk. For example, consider the situation where a trader buys a stock at an extreme price then sells a short time later for a profit. He might find out later that evening that the trade has been broken and is now net short. In the intervening time the market may have risen substantially, resulting in a sizable loss. Because of this possibility, many traders will pull out of the market when there is any evidence of trading irregularity. They may do this on a market-wide scale, and even if the trade problem is small and relatively isolated, it could result in extreme price volatility throughout entire market. A fair way to address this issue is to allow the subsequent chain of trades following the initial broken trade to also be broken. A trader should never be punished for providing liquidity at worst he/she should be made flat.
2. The "Pattern Daytrader" rules also may contribute to extreme volatility. These rules exclude traders who have accounts smaller than $25,000 from trading more than a few times per week. Because this group is no longer participating in the market, there are fewer 'minds', thus fewer opinions represented. Thus it becomes statistically more likely that extreme moves will occur with greater frequency. In any case, there is reason to question the value of this rule. This was based on the belief that "big money" is smarter than "small money", and that small traders need to be protected from themselves. This is a premise which has been proven spectacularly wrong in recent years.
Please be careful when modifying regulations for the purpose of affecting the natural price action. Often the unintended consequences can be worse that the problem that is being 'solved'. A fair and level playing field is the best way ensure an orderly market.