2010-05-06

What the hell happened?

Rumors go as far as malicious hacking, cue Tom Clancy, Debt of Honor. That was also the book that had the plane flying into the Capitol building. The sequel had Iran invading Iraq and becoming a Muslim superstate...

One theory that sounds plausible is that the shutting down of computers caused the crash. Did Shutdowns Make Plunge Worse? ZeroHedge has covered the large amount of computer trading in the market for the past year on their site, but I found this interview with Joe Saluzzi discussing a situation that may be similar to what happened.

From Sense of Cents, an interview with Joe Saluzzi, who was often on ZeroHedge.
53:25 – What is the risk or potential that HFT could crash the market? What is pushing the market higher currently?
Saluzzi talks about the volume going away and says the HFT (high frequency traders) would not dump into the market, but rather they wouldn't be there to buy, but if you wanted to sell, there'd be no buyers. He says an intraday event could cause them all to sell, if they were caught long before an adverse event.

Either scenario could be in play here. From the WSJ article:
A number of high-frequency firms stopped trading Thursday in the midst of the market plunge, possibly adding to the market's selloff.

Tradebot Systems Inc., a large high-frequency firm based in Kansas City, Mo., closed down its computer trading systems when the Dow Jones Industrial Average had dropped about 500 points, said Dave Cummings, founder and chairman of the firm.

Tradeworx Inc., a N.J. firm that operates a high-frequency fund, also stopped trading during the market turmoil, according to a person familiar with the firm.
If they turned off their computers in the midst of an adverse event, that could mean liquidity dried up, if many other firms did the same thing. If you went to sell, perhaps due to a stop order, the stock could fall until someone was willing to buy.

The New York Times is running with the HFT theme as well in High-Speed Trading Glitch Costs Investors Billions

The cynical bearish view is that the computers have just been trading with each other, slowly moving stock prices higher to restore confidence in the public. These firms execute trades in milliseconds and a firm could buy and sell one stock multiple times in one second. Since they're not trading on fundamentals, all the Federal Reserve would have to do, for instance, is push the HFT algorithms into buying patterns, which might not take all that much capital.

I would need to see hard evidence of that before I believe it, but the reality is that computer algorithms may be responsible for a large amount of market volume and that raises the question of whether the current stock prices are accurate or not; whether HFT just create noise around the "real" buyers and sellers in the market, or whether they have in fact become the market. Did the noise stop today? Or did the noise become harmonic to the downside? Or is there another, perhaps completely benign explanation? Hopefully there'll be more answers in the morning.

Mish Shedlock has some good comments on the topic in Black Swan in Computer Trading? Nasdaq to Cancel Some Trades; Plunge Raises Alarm on Computerized Trading
Computers vs. Computers

In essence computers trading against computers decided at some point today to throw in the towel and not bid.

At some point (manual intervention?) they all decided to bid again, driving stock prices back up. This is what our stock market casino has become.

Lovely, isn't it?

I have been waiting for this to happen and today it did. Supposedly, computer trading lowers volatility and bid/ask spreads for traders. Today we see that works until it doesn't.

Most of the day Citigroup was erroneously blamed for the plunge. Citigroup was not to blame, flash-trading computers vs. computers with fake orders appears to be the culprit.

Who benefits from that? In general, Goldman Sachs. Perhaps I am wrong but I bet they had a great day.
He goes on to say:
Nasdaq has set the screw-job limit at a whopping 60% threshold. If you lost 45% today with a stop loss in the wrong spot you just may be out of luck.

It's just what we need to inspire confidence.

Black Swan Event?

By the way, this was not really a "black-swan" event. This was perfectly predictable although timing it was not. I have been discussing this scenario with a few friends for months.

I have one question for the computers: Did someone manually intervene triggering your huge afternoon buy program or did you simply figure out on your own accord there were no more stops to run?

Regardless, a whole bunch of people with "far away" sell stops got taken to the cleaners today.

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