Stock market shock explained

PHILIPBALL

Some lost hundreds of millions in September's twenty minute trading frenzy. © GettyImages

Two physicists have an explanation for the convulsion of the stock market just ten days ago that left traders reeling and economists scratching their heads. The market was behaving like a muffled guitar string, they suggest, thanks to short-termism and technological limitations. 

The 20-minute trading frenzy on Friday 20 September saw one bank loose £100 million while another dealer racked up £1 million profit in three minutes. More shares changed hands than are often traded in an entire day. 

It began at around 10.10 am; by 10.15 the FTSE 100 index - a barometer of the market's overall health - had soared from around 3,860 to 4,060. Minutes later it plummeted to 3,755 before eventually levelling off close to its starting point.

Economists struggle to understand these rare, earthquake-like anomalies that they dub, rather vaguely, turbulence. But to Sorin Solomon and Lev Muchnik of the Hebrew University of Jerusalem, Israel the event of 20 September looks more like another physical phenomenon: damped oscillation.

Solomon and Muchnik have built a computer program that simulates trader-trader interactions for a wide range of different trader strategies; the model borrows ideas from the physics of colliding gas particles. They searched for a set of simple 'psychological' rules that would produce the spike seen on the 20 September.

The model generates damped oscillations if there are three types of traders: random traders, who buy and sell at small random deviations from the current market price, market-maker traders who occasionally induce large price fluctuations, and inertial traders who base their orders on what they did in the previous transaction. 

All the traders are opportunists. "They are interested in short-term profits and anxious not to miss a trend," says Solomon. If everyone else is buying, they'll tend to buy too, leading to herding behaviour that amplifies small price fluctuations into big ones. 

Traders anxious not to miss a trend can cause these oscillations. © S.Solomon

If prices drift too far from what the traders believe is their fundamental value, they'll slow down and eventually reverse their behaviour. This makes the prices oscillate around their fundamental value. 

But another process damps out these oscillations: a kind of friction produced by the way traders follow the market rather sluggishly. In the 20 September event, it seems that technological limits on how fast a transaction can be made may have slowed the market's response.

Explanations like this might not be unique, but by being based on the behaviour of the market as a whole they contrast with the way that economists typically seek to pin anomalies on specific causes. Some have blamed the 20 September turmoil on trading errors made by the Swiss-owned Credit Suisse First Boston and by Deutsche Bank. 

A similar frenzy last year was traced to a deal by a trader for the US-based Lehman Brothers that was 100 times bigger than he'd intended. But single errors can't swing the whole market. That happens when other traders react - the effects of which conventional economic models fail to predict.