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ELECTRONIC TRADING STRATEGIES

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Is su e 6 Un ited St at es | F eb ru ar y 2 4 , 2 010

FOCUS ARTICLE: SHORT SALE PRICE TESTS


Kilian Mie
kilian.mie@gs.com The Securities and Exchange Commission will announce its decision on amendments to
NY: 917-343-8529 Regulation SHO on Wednesday, February 24, 2010. One of the proposals the
Commission has been considering is a “circuit breaker” for securities during severe
price declines. We provide historical analysis on the frequency of such a scenario
Ingrid Tierens assuming that a severe price decline is defined as a drop in the stock price of at least 10%
ingrid.tierens@gs.com compared to the previous day’s close.
NY: 212-357-4410
 From January 2008 until February 2010, about 2% of the current S&P 500
constituents hit the -10% price test. This translates into 11 S&P 500 names
per average trading day. The corresponding numbers for the current Russell
Goldman Sachs Electronic 2000 universe are 4% of the index, or 79 names per average trading day.
Trading Strategies
This material has been  The number of price declines fluctuated significantly during the past two
prepared by Goldman Sachs years. In October 2008, 15% of the current S&P 500 index (74 names per
Electronic Trading Strategies average trading day) would have been impacted by the price test, while year-to-
and is not a product of
Global Investment Research
date only 0.2% (one name per average trading day) hit the -10% limit.
or Fixed Income Research.
Important disclosures
 Weighting the results by traded volume to account for liquidity differences across
appear at the end of this securities, we find that on average 3.2% (6.3%) of the dollar volume traded for
material. the current S&P 500 (Russell 2000) constituents would have hit the -10%
price limit from January 2008 until February 2010.
Number of stocks per average trading day dropping by at least 10% intraday
S&P 500 Russell 2000
400
Number of stocks per average trading day

350

300

250

200

150

100

50

0
Nov-08

Nov-09
Jan-08

Jun-08
Jul-08

Jan-09

Jun-09
Jul-09

Jan-10
Feb-08
Mar-08
Apr-08
May-08

Aug-08
Sep-08
Oct-08

Dec-08

Feb-09
Mar-09
Apr-09
May-09

Aug-09
Sep-09
Oct-09

Dec-09

Feb-10

Source: Bloomberg, Russell, Standard & Poor’s, Goldman Sachs Electronic Trading Strategies

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 1


 

FOCUS ARTICLE: SHORT SALE PRICE TESTS

The Securities and Exchange Commission will announce its decision on amendments to
Regulation SHO on Wednesday, February 24, 2010. One of the proposals the
Commission has been considering is a “circuit breaker” for securities during severe
price declines, with short selling for securities that meet the circuit breaker price test only
allowed at a price above the current national best bid.

We assume in this article that a severe price decline is defined as a drop in a security’s
price of at least 10% compared to the previous day’s close, and we analyze how often
these price declines occurred since the start of 2008 for the current constituents of the
S&P 500 index and the Russell 2000 index.

More specifically, for each constituent of the S&P 500 and Russell 2000, we calculate a
daily “low return” defined as the percentage return of the stock’s low during the trading day
compared to the previous day’s close. If this “low return” is -10% or worse, the stock is
flagged as a circuit breaker candidate. Exhibit 1 summarizes the frequency of these circuit
breaker events for the entire sample period from January 1, 2008 until February 22, 2010.
With 539 distinct trading days and 500 (1996) current constituents in the S&P 500 (Russell
2000), we have 269,500 (1,075,844) potential daily circuit breaker events in the S&P 500
(Russell 2000) universe. The S&P 500 constituents experienced daily price declines of
10% or more 5,731 times over the past 26 months, while the Russell 2000 constituents
recorded more than 42,000 such events. In other words, 2.1% of the current S&P 500
constituents hit the -10% circuit breaker since January 2008, which translates into
about 11 S&P 500 names per average trading day. The corresponding numbers for
the current Russell 2000 universe are 3.9% of the index, or 79 names per average
trading day.

Exhibit 1: Frequency of daily “low returns” of -10% or worse (Jan 2008 – Feb 2010)
S&P 500 Russell 2000
-10% circuit breaker events 5,731 42,426
Trading day / stock combinations 269,500 1,075,844
Proportion of index universe 2.1% 3.9%
Number of stocks per average trading day 10.6 78.7
Source: Bloomberg, Russell, Standard & Poor’s, Goldman Sachs Electronic Trading Strategies

The overall summary does however mask significant variation throughout the sample
period. Exhibit 2, which shows the analysis on a monthly basis, underscores how the
market turmoil during the fall of 2008 and the subsequent overall market decline during the
first quarter of 2009 tilted the numbers. In October 2008, the proportion of all possible
combinations of trading days and current Russell 2000 constituents flagged as “-10%
circuit breaker” events jumped to almost 15% for the current S&P 500 universe and 18%
for the current Russell 2000 universe. On average, more than 70 S&P 500 names and
more than 350 Russell 2000 names hit the trigger each trading day of that month. During
the past two months on the other hand, only 0.2% of the S&P 500 index (about one
stock per average trading day), and less than 1% of the Russell 2000 index (slightly
more than 10 stocks per average trading day) experienced “low returns” of -10% or
less.

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 2


 

Number of stocks per average trading day Proportion of current index universe

0
50
100
150
200
250
300
350
400
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%

Jan-08 Jan-08
Feb-08 Feb-08
Mar-08 Mar-08
Apr-08 Apr-08
May-08 May-08
Jun-08 Jun-08
Jul-08 Jul-08
Aug-08 Aug-08
Sep-08 Sep-08
Oct-08 Oct-08
Nov-08 Nov-08
Dec-08 Dec-08
S&P 500
S&P 500

Jan-09 Jan-09
Feb-09 Feb-09
Mar-09 Mar-09
Apr-09 Apr-09
May-09 May-09
Russell 2000
Russell 2000

Jun-09 Jun-09
Jul-09 Jul-09
A. Proportion of current index universe

Aug-09 Aug-09

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR


Sep-09 Sep-09
B. Number of stocks per average trading day

Oct-09 Oct-09
Nov-09 Nov-09
Dec-09 Dec-09
Jan-10 Jan-10
Feb-10 Feb-10
Exhibit 2: Monthly frequency of -10% or worse “low returns” (Jan 2008 – Feb 2010)

3
 

Proportion of current index Number of stocks per


universe average trading day
S&P 500 Russell 2000 S&P 500 Russell 2000
Jan-08 1.0% 2.8% 4.9 56.0
Feb-08 0.2% 1.3% 1.2 26.0
Mar-08 0.6% 2.1% 2.8 41.8
Apr-08 0.2% 1.2% 1.2 24.6
May-08 0.1% 1.1% 0.6 21.5
Jun-08 0.3% 1.3% 1.6 26.7
Jul-08 1.4% 2.7% 6.8 54.7
Aug-08 0.4% 1.7% 2.2 33.9
Sep-08 4.7% 6.0% 23.5 120.2
Oct-08 14.7% 18.0% 73.6 358.6
Nov-08 8.9% 14.6% 44.6 292.0
Dec-08 4.5% 10.1% 22.7 202.4
Jan-09 3.7% 7.4% 18.3 147.3
Feb-09 4.0% 6.8% 19.8 135.0
Mar-09 4.1% 8.4% 20.5 167.8
Apr-09 2.1% 4.2% 10.4 84.3
May-09 1.5% 3.8% 7.3 76.8
Jun-09 0.4% 2.7% 2.1 53.0
Jul-09 0.5% 1.6% 2.5 32.1
Aug-09 0.1% 1.4% 0.7 27.3
Sep-09 0.1% 0.7% 0.6 14.8
Oct-09 0.2% 1.5% 1.1 30.6
Nov-09 0.2% 1.0% 0.8 19.9
Dec-09 0.1% 0.4% 0.3 7.3
Jan-10 0.2% 0.6% 0.9 11.3
Feb-10 0.2% 0.7% 1.2 14.8

Source: Bloomberg, Russell, Standard & Poor’s, Goldman Sachs Electronic Trading Strategies

Less liquid, more volatile names are expected to be more affected by the circuit
breaker proposal. While the previous analysis treated all stocks equally, Exhibit 3 tries to
account for liquidity differences by weighting each circuit breaker event by the composite
dollar volume traded for each affected stock on the day it hit the -10% limit. For each
month in our sample, we sum the dollar volume of all impacted stocks and divide it by the
total dollar volume traded for all constituents in its index universe.
Exhibit 3: Volume-weighted frequency of -10% trigger events (Jan 2008 – Feb 2010)

S&P 500 Russell 2000


25%
21.8%

20%
Proportion of $ volume traded

15.8%

15%

10%
7.5%

5% 3.7%
3.3% 0.6%

0%
Nov-08

Nov-09
Jan-08

Jun-08
Jul-08

Jan-09

Jun-09
Jul-09

Jan-10
Feb-08
Mar-08
Apr-08
May-08

Aug-08
Sep-08
Oct-08

Dec-08

Feb-09
Mar-09
Apr-09
May-09

Aug-09
Sep-09
Oct-09

Dec-09

Feb-10

Source: Bloomberg, Russell, Standard & Poor’s, Goldman Sachs Electronic Trading Strategies

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 4


 

On average, 3.2% of the $ traded volume for the current S&P 500 constituents was
impacted by the -10% price test since January 2008. The number was almost twice
as large for the current Russell 2000 universe (6.3%). Again, the averages are driven
by extreme numbers (15.8% for the S&P 500 and 21.8% for the Russell 2000) observed
during October 2008. Month-to-date as of February 22, 2010, only 0.6% of the S&P 500
traded volume and 3.7% of the Russell 2000 traded volume belonged to stocks that hit the
trigger level.

Exhibit 4: Volume-weighted frequency of -10% trigger events by sector (Jan 2008 –


Feb 2010)

S&P 500 Russell 2000


10%
8.7%
Proportion of $ volume traded

9%
8% 7.3%
7.0%
6.7% 6.3% 6.6%
7% 6.3%
5.8%
6% 5.3%
5% 4.6% 4.6%

4% 3.5%
3.0%
3% 2.4%
1.9% 1.9% 1.9% 1.8%
2% 1.4%
1.0%
1%
0%

Industrials
Energy

Utilities
Discretionary

Consumer Staples

Financials

Technology
Information

Materials

Telecommunication
Health Care
Consumer

Services
Source: Bloomberg, Russell, Standard & Poor’s, Goldman Sachs Electronic Trading Strategies

Exhibit 4 slices the traded volume analysis by sector. Not surprisingly, financials
dominated the S&P 500 price test events with 7.3% of the sector’s dollar volume
traded impacted by the test. In the small-cap universe, the utilities sector was a
noticeable outlier with only 1.4% of its dollar traded volume affected.

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 5


 

TRENDS IN ESTIMATED SHORTFALL, BID-ASK SPREADS, VOLUME AND VOLATILITY


 

 Estimated shortfall
showed an uptick in
February 2010.

 Similarly, quoted half-


spreads increased for
S&P 500, and hardly
changed for Russell
2000.

 Month-to-date dollar
volumes are comparable
to January.

 Volatility measured over


21-day rolling windows
declined until the
beginning of the year and
moved upward in
February 2010.

 
Source: Bloomberg, Reuters, Russell, Standard & Poor’s, Goldman Sachs

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 6


 

SECTOR ANALYSIS FOR CORRELATIONS, BID-ASK SPREADS AND VOLATILITY


 

 For most sectors,


correlation levels
across stocks
increased, in particular,
for the S&P 500.

 Quoted half-spreads
are generally lower
compared to levels
experienced over the
past six months.

 For the S&P 500 index,


the uptick in volatility at
the index level is
mirrored at the sector
level, with the exception
of the Telecoms sector.

 
Source: Bloomberg, MSCI GICS, Reuters, Russell, Standard & Poor’s, Goldman Sachs 

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 7


 

APPENDIX
Expected shortfall
This number relies on the Goldman Sachs Shortfall Model (GSSM) and assumes trading a $500 mn
portfolio over a full trading day. The order size for each of the stocks in the corresponding index
(S&P 500 or Russell 2000) equals the index weights times the size of the portfolio ($500 mn). We
use the GSSM to generate the expected shortfall (all-day executions) for each of the index
constituents in bps and calculate a weighted average of these individual expected shortfall numbers,
using the index weights. We calculate this number for each trading day during the month. The
candle sticks in the plot display the median expected shortfall (in bps) during the month, as well as
the minimum, maximum, 10th percentile and 90th percentile.
Quoted half-spread
We compute the market cap weighted average quoted half-spread (half of the bid-ask spread) across
the stocks in the corresponding index (S&P 500 or Russell 2000) for each trading day during the
month. The candle sticks in the plot display the median of the weighted average quoted half-spread
(in bps) during the month, as well as the minimum, maximum, 10th percentile and 90th percentile.
Quoted half-spreads for sectors
We compute the market cap weighted average quoted half-spread (half of the bid-ask spread) across
the stocks in the corresponding GICS sector in the corresponding index (S&P 500 or Russell 2000)
for each trading day during the past 6 months. The candle sticks in the plot display the median of the
weighted average quoted half-spread (in bps) during the past half year, as well as the minimum,
maximum, 10th percentile and 90th percentile for each sector and for the overall index. In addition,
the blue square marks the most recent weighted average quoted half-spread.
Stock correlations within sectors
For each stock within the corresponding GICS sector in the corresponding index (S&P 500 or Russell
2000), we calculate its volatility over a rolling 21-day window using daily returns. We similarly
calculate the volatility of the sector returns over the same time horizon. It can be shown that the
average stock correlation within the sector can be proxied by the ratio of
 the sector variance (the square of the sector volatility) minus the weighted sum of the
variance of each stock in the sector, where the weights are the squares of the market
capitalization weights of each stock within the sector, and

 the sum of each pairwise product of a stock’s volatility with another stock’s volatility, each
weighted by their market capitalization weight in the sector.
The candle sticks in the plot display the median correlation during the past 6 months, as well as the
minimum, maximum, 10th percentile and 90th percentile for each sector. In addition, the blue square
marks the most recent stock correlation.
Volatility
We calculate the standard deviation of the daily returns for the corresponding index (S&P 500 or
Russell 2000) over a rolling 21-day window for each trading day during the month. The candle sticks
in the plot display the median volatility (in annualized percentage) during the month, as well as the
minimum, maximum, 10th percentile and 90th percentile.
Volatility for sectors
We calculate the standard deviation of the daily returns for the corresponding GICS sector in the
corresponding index (S&P 500 or Russell 2000) over a rolling 21-day window for each trading day
during the past 6 months. The candle sticks in the plot display the median volatility (in annualized
percentage) during the past 6 months, as well as the minimum, maximum, 10th percentile and 90th
percentile. In addition, the blue square marks the most recent sector volatility.
Volume
We sum the dollar volume across the stocks in the corresponding index (S&P 500 or Russell 2000)
for each trading day during the month. The candle sticks in the plot display the median volume (in
$mn) during the month, as well as the minimum, maximum, 10th percentile and 90th percentile.

GOLDM AN S ACHS ELECTRONIC TRADING STRATEGIES | STREET COLOR 8


 

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