The CME Group has several measures in place to deter extreme market moves. One such measure is the Velocity Logic. By monitoring predefined parameters in futures markets, it helps prevent the market from making too extreme and fast movements over a given period.
What is Velocity Logic?
Velocity Logic is a market integrity control measure deployed on the Chicago Mercantile Exchange (CME) Globex trading platform. It looks for potential significant price movements within predefined upper and lower limits.
The mechanism is intended to monitor futures price movements that would go too far, too fast. The goal is to curb potential extreme market movements and help retain a healthy trading environment on the exchange.
How it Works
Once triggered, the Velocity Logic mechanism checks each arriving order against predefined upper and lower limits to ensure the price doesn’t significantly exceed these limits within the given trading period.
If the system determines that a potential trade will violate any Velocity Logic limits (VL High or VL Low), the market enforces an immediate suspension in matching orders, effectively pausing trading. This sends the market into a Reserved state until fair prices can be re-established.
The temporary halt in trading also allows market participants to reassess the situation and make trading decisions based on current information rather than panic.
Note that the suspension affects both futures and options markets.
For example, on August 23, 2015, Gold futures trading was suspended for 10 seconds after a sudden drop in gold price triggered a Velocity Logic event.
How Does Velocity Logic Affect Your Trading?
It is essential to understand what happens when Velocity Logic is triggered and get familiar with the factors responsible for activating the mechanism since they directly impact the market, thus, your trading strategy.
Let’s say you are trading a futures instrument that belongs to the metals, Forex, equities, treasury, or energy groups. If a Velocity Logic event gets triggered, the entire group of related instruments is transitioned to its Pre-Open state (e.g. not only Gold but all metals) – the earliest possible market phase for the day. It allows traders to enter, modify, or cancel orders.
On the other hand, if the futures instrument doesn’t belong to the groups mentioned above, only the particular market is transitioned into a Reserved or Paused state.
Another thing to know is that when Velocity Logic comes into effect in the futures market, it also impacts the corresponding options market. If trading halts in a futures market, trading in the corresponding options market also pauses, and all mass quotes are canceled.
You can use the time while trading is suspended to factor in recent information and make any necessary adjustments to your strategy.
What Happens During a Reserved State?
When the Velocity Logic mechanism is enforced and the market enters a Reserved state, traders will receive a Security Status (tag 35-MsgType=f) message notifying them.
While the market is in a reserved state, a timer tracks the period for which trading is halted. The time frame may vary depending on the reasons that triggered the Velocity Logic event in the first place.
Market Reopens
Before the market returns to its active state, it will undergo Indicative Opening Price verification. The process aims to determine an expanded price range to measure the potential Indicative Opening Price values.
If they fall within the newly expanded range, the market reopens, and traders get notified of the Indicative Opening Price to resume trading. However, if they fall outside the extended range, the market will remain in the Reserved state, and the system will perform another Indicative Opening Price verification. This process will continue until the market falls within the price range.
Furthermore, it is essential to note that the Reserved state will remain in effect for a few seconds after the market reopens.
In the corresponding options market, trading will resume after the Velocity Logic event in the futures market has been resolved. There is no Indicative Opening price. Instead, price discovery is determined by customer quote submissions.
Dynamic Circuit Breakers and Velocity Logic
Velocity Logic functions like a circuit breaker, though not necessarily in the traditional sense.
In trading, a circuit breaker is an emergency-use market regulatory measure that temporarily halts trading on an exchange when prices exceed predefined levels, e.g., upper and lower limits. The circuit breaker kicks in if the security price moves too far away from these price bands. Its primary function is to prevent the implications of potential mass panic and follow-up market instabilities.
There are three levels of circuit breakers in the stock market. The first is a 15-minute trading pause that triggers if the market sustains a 7% loss. A recent example of when a Level 1 Circuit Breaker was triggered is when the S&P 500 fell 7% in March 2020 following the COVID-19 pandemic news.
The second level is triggered when there is a 13% drop, resulting in trading being suspended for an additional 15 minutes.
Level 3 is triggered when the market drops 20%, in which case trading is halted for the rest of the day.
In contrast to traditional circuit breakers, Velocity Logic doesn’t just check if the market movement has gone too far from the predefined levels but also if it has moved too fast. As such, it is possible for price movements to pass the price band validation but fail the speed validation and, in turn, trigger a Velocity Logic event.
Velocity Logic was initially called “Dynamic Circuit Breakers (DCB)”. CME suggested it as an alternative to the 1-second minimum quote life recommended by the National Cattlemen’s Beef Association (NCBA).
What Happens if a DCB is Triggered?
The main difference between traditional and dynamic circuit breakers is that DCBs move with the market throughout the day. Within specific time intervals (usually an hour), dynamic circuit breakers define an upper and lower limit within which the instrument price can move. Moving past these limits triggers the DCB functionality.
If the DCB is triggered in a lead month for the primary contract as designated by the Global Command Center (GCC), all corresponding contract markets are immediately transitioned to a Pre-Open state. This usually lasts around two minutes with no monitoring period. On the flip side, if the DCB is triggered in a non-lead month, only the triggering instrument will transition to the Reserved state.
DCB Variant Calculation
The DCB variant is calculated as a percentage of an instrument’s previous settlement price. Each instrument uses its own assigned percentage to calculate its DCB variant.
The formula is: Previous Days Settle x Assigned DCB Percentage Value = DCB Variant.
Both the Velocity Logic and dynamic circuit breakers share the same logic for calculating the variant.
Calculating the Velocity Logic variant is essential because it helps determine the upper and lower limits throughout the course of the trading session.
During trading, a rolling look-back window identifies the high and low prices from the previous time interval. A look-back window is a pre-configured time interval that is always trailing from the current moment. The high and low values plus or minus the Velocity Logic variant determine the high and low limits for the present time interval.
Benefits of Incorporating Velocity Logic into Your Trading Strategy
While Velocity Logic enforcement and the resulting trading halt are out of your control as a trader, you can use these events to ensure a better position once the market reopens.
If you’re a buy-and-hold investor, Velocity Logic might not affect your approach to the market much. That being said, if an entire market group is forced to suspend trading for a predetermined period, it might be a reason to review your portfolio and adjust its risk exposure.
If you’re a day trader, using Velocity Logic events to reevaluate your position by incorporating the most recent market information can be a huge difference-maker.
Key Takeaways
- Velocity Logic is a market control functionality that detects when the price of a traded futures instrument within a configured time interval exceeds set limits with too much, too fast;
- When in effect, the Velocity Logic mechanism will suspend trading momentarily, and the market is transitioned to a Reserved state;
- If the instrument belongs to the energy, metals, equities, Forex, or treasury groups, the entire group of related instruments traded on that exchange transitions into a Pre-Open state;
- While Velocity Logic events are only triggered in futures markets, they impact the corresponding instrument(s) in the options market as well;
- Traders will receive a Security Status notification when Velocity Logic is in effect and will also be notified when the market reopens;
- There’s no order matching when the market is in a Pre-Open or Reserved state. Traders can use this opportunity to reassess the situation and make trading decisions based on current market information;
- Velocity Logic functions similarly to dynamic circuit breakers.
