Thursday, September 4, 1997
Wise Innumeracy
by
Mark Brady
I really shouldn't watch the talking heads but I found myself eating lunch in front of the TV and so switched to the financial channel. The anchor was working himself into a state of frenzy over the high volatility of the market.
So how did he prove his theory? He focused on the number of trading halts that had been called under Rule 80A, the details of which can be found at: www.nyse.com/public/glos/glsc6.html. Essentially, it states that if the Dow shifts more than 50 points from the previous day's close, trading restrictions are put into place. The talking head had statistics proving that trading halts were being called more and more frequently, over once a day so far this year. He attributed these halts to the increasing volatility of the market. He then interviewed some Wall Street gooroos who said the same thing, although one opined that the increase in volatility had something to do with the Dow's high levels.
Well, the last expert was right, but I suppose that you would have to pay his fees to get the complete explanation. I will be happy to give it to you for free. We are seeing wide point swings in the Dow because the Dow is at a higher level. Let's say the Dow swings 1% a day. At 2400, this would be 24 points. At today's level of around 8000, that's 80 points. Either way, it is a 1% swing. The Dow is nothing but an arbitrary index, multiply it by 10 and we would expect to see point swings that are 10 times as large. The same is true of a stock price; you shouldn't care if a share is $25 or $250, all you should care about is what the percentage increase (or decrease) is.
The problem is that Rule 80A cares. The wise people from the NYSE who wrote this rule in 1990 did not understand numbers. If the Dow was at 2500, 50 points would have been a 2% move. The logical thing would have been to use a percentage rather than a flat number to trigger the circuit breakers. That two percent translates now to 160 points. Very few trading days have reached that number this year. The rules, instead of decreasing the perception of volatility, have caused the talking heads to complain about all this increase in volatility and how the market must be riskier. It is working against what the rule was designed to do because the authors did not understand math. This is compounded by the fact that the talking heads who report on this are just as bad at figures.
So, what will cause the Wise to change these rules to a percentage basis? My guess is that it probably will not occur until Rule 80B starts taking effect. That rule stipulates that trading will be halted for 30 minutes for a swing of 350 points and an hour for a swing of 550 points. At 1990 levels, this would be swings of 14% and 22%, big swings indeed. At current levels, this translates to only 4.4% and 6.9%. When 80B trading halts become common and brokers start losing their commissions, then the NYSE might consider correcting their Rule.
Foolishly yours for a small percentage,
Mark Brady