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On the morning of 1 August 2012, Knight Capital’s order router was trying to fill 212 customer orders. In the first 45 minutes after the US market opened, it sent more than 4 million orders. By the end, the firm had traded more than 397 million shares, picked up several billion dollars of unwanted positions and lost more than $460 million.
The cause, set out by the US Securities and Exchange Commission (see the SEC press release), was mundane. In 2005, moving a section of code left a function in the router defective. It was not meant to be used, but it stayed there. In late July 2012, new code was deployed incorrectly in the same router, and certain orders triggered the old function. It could no longer recognise when an order had been filled, so it kept sending more.
One detail stands out. Before the market opened that morning, an internal system sent 97 automated emails that referred to the router and identified an error. They had not been designed as alerts, and Knight did not act on them that day.
Retail traders can now run automated strategies from a laptop. The sums are far smaller than Knight’s, but the risk has the same shape: software doing exactly what it was told, faster than anyone can watch. For an individual, the account can still be gone before lunch. Three controls cover most of that risk.
Put a hard limit outside the strategy. The SEC found that Knight’s financial controls could not stop orders that exceeded its pre-set capital thresholds. The retail equivalent is a maximum daily loss and a maximum position size, set at broker or platform level wherever possible. A limit written inside the strategy can fail with the strategy.
Watch it while it runs, and decide what a warning means. Knight had 97 emails and no one acting on them. Before going live, decide which messages mean you stop trading, send them somewhere you will see them, and make sure you know how to switch everything off and close open positions in under a minute. A strategy left running on a server is the easiest one to forget.
Check the deployment and the data before real money goes in. The SEC also pointed to the lack of a control comparing the orders leaving the router with those entered. A trader can do a simpler version: start small, compare what the strategy intended with what the broker executed, and reconcile fills and costs against the broker statement. Then delete any code you no longer use. Knight’s defective function was never meant to run.
Knight agreed to pay $12 million to settle the SEC’s charges in 2013. Few retail traders will ever face a regulator, but the lesson carries over. Automation takes emotion out of execution. It does not remove the need for someone to answer for what the software does. Anyone starting out can find the basics in this practical guide to algo trading.
Benjamin Roure L’Hermitte is the founder of Tradoshi, a trading journal, and spent nine years in financial control.
