Tuesday, September 27, 2011

SEC Proposes New Stock Market Circuit Breakers: An Unneeded Rule

From Bloomberg, "SEC Proposes Cutting Threshold for Trading Halts" by Nina Mehta:
The Securities and Exchange Commission began an overhaul of rules adopted after the Crash of 1987 designed to shut down the stock market during periods of volatility
S&P 500 declines of 7 percent, 13 percent and 20 percent from the prior day’s close would set off halts across all markets, narrowing the current thresholds of 10 percent, 20 percent and 30 percent, according to the SEC.
Read the complete article here.

With the volatility index, VIX, at double its historical average, the potential to reach a lower circuit breaker limit is much greater than its been in the past. The VIX is currently trading at around 36, which translates into a daily VIX of around 2.25 and more, if the VIX goes back to its recent highs in the 40s.. The 7 percent suggested SEC limit is about 3 standard deviations. A 3 standard deviation event, on the loss side, is expected to occur about 1.5 times out of a thousand. A thousand trading days is approximately four years. So, we should expect the SEC circuit breakers to kick in on average at least 3 times every 8 years.

Of course, stock prices are information about value, changes in a company's profit outlook, the economy, and the pricing of risk.

Trading and the disclosure of prices are a form of speech about the current value and future value of the security, its expected cashflows and riskiness. Any curtailment of the right to speech, except in the cases allowed by the US Supreme Court, is an abridgment of first amendment constitutional rights. Volatility, even extreme volatility, while annoying and at times unsettling, does not cause physical harm, or the potential for physical harm, to persons or property. It is not equivalent to yelling fire in a crowded theater. It can cause an economic loss if someone trades at a temporary low price relative to the prices before and after the temporary dip, but trading is a voluntary activity. Why do we need to protect sellers from an activity they chose to do, i.e. sell all or part of their stock investment during periods of high volatility?

Clearly if temporary occurring extreme volatility is a problem, the markets would develop a trading order that limited selling during a short period of high volatility and sellers would develop better skills at assessing the duration of the impact on prices of information.

New information can cause big price jumps and new information and rumors about the economy, government policy or legislation can cause big price changes. Financial economists have long known about price jumps and have developed and used jump diffusion modeling processes where appropriate.

We do not need the government and the SEC to write short term puts for big drops in stock market prices. Let the markets develop their own mechanisms for dealing with occasional temporary price dives.

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