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Monday, May 10, 2010

Weird Stock Market Behavior on Thursday

On Thursday, the stock market unexpectedly dropped sharply, and then rebounded. There were weird huge drops in Accenture (ACN), Apple (AAPL), Procter & Gamble (PG), and others.

It seems that an single person/bank is responsible for the huge drop. One explanation is that a single huge trade was entered. It was either for a single stock, a basket of stocks, an index future, or an ETF.

Suppose someone sold a huge bunch of index futures. Some market maker would buy those futures. He then would sell the stocks in the index, to hedge. Just looking at the stock trades is insufficient to figure out the cause of the problem. You also have to look at index futures. Some sources say there was a lot of unusual selling in S&P 500 futures, which led to the stock market declining as traders hedged those futures.

This is somewhat of a problem. Stocks are regulated by the SEC. Index futures are regulated by the CFTC.

Some of the trades may be canceled. That is potentially unfair. What is the cutoff? What if someone bought options to hedge the stock? It would be unfair to cancel the stock trade but not also the option trade.

It seems that a cutoff of 60% was chosen, which seems obviously too wide of a cutoff. However, suppose someone bought stock at a cheap price and later sold or hedged. It is unfair to cancel one trade but not the other.

This also illustrates the stupidity of using stop-loss orders. If you had a stop-loss order, you would have sold your shares at a lousy price. When the market tanked and then rebounded, your stop loss order would have been activated.

Instead of using stop-loss orders, you should sell some of your shares. Even better, you should sell stocks and buy gold/silver. You should take physical delivery of your metal. It was amusing to see gold skyrocket while the stock market tanked. Until Thursday, this year had been relatively favorable for stocks compared to gold.

How can one bad trade cause the entire market to decline? There are computer programs that assume stocks are correlated. P&G and Microsoft are both Dow members. This makes them somewhat correlated. When P&G tanked, computer algorithms automatically moved down other Dow stocks, assuming they're correlated. Once traders realized what was going on, they turned off their computer program and started buying.

I read another interesting quote. One trader said "We knew that some trades would be canceled. Therefore, we turned off our algorithm." That's one reason that all the offers in those stocks disappeared. Knowing trades would be canceled, market makers pulled all their quotes.

It was interesting to see some mainstream media writers say "This incident makes individuals question the wisdom of investing in the stock market." The best way to protect your savings is to buy gold/silver and take physical delivery. Also, if you didn't panic and sell, the anomaly didn't affect you.

Suppose a trader really did enter a huge sell order by mistake. Those trades are not sent out all at once as one huge order. One huge sell order would be obviously suspicious. The specialist on the NYSE would probably halt the stock if he saw a suspicious huge order. It would have been broken up into a bunch of small sell orders. Each order would not be suspicious, by itself.

This is now a common practice. Traders break up huge trades into tiny pieces. There are computer algorithms that look for someone else who is making a huge sell order in little pieces. They try to sell ahead of the algorithm, so they can buy back later at a better price. In this manner, one huge sell order could cause other computer algorithms to start selling.

Suppose one trader made a huge sell order by mistake. That trader is not solely to blame. The bank is supposed to have limits on each trader. Suppose a trader has a $10M limit. Then, the bank's computers are supposed to automatically cut him off if he makes a trade bigger than $10M, either as one trade or as a combination of trades.

The NYSE is supposed to close if there's a big drop in one day. However, the cutoff is 10%, and it was just barely not reached. There probably should also be a per-stock rule. I.e., if a stock drops by 5% in 5 minutes, automatically halt it for 10 minutes.

The NYSE has a per-stock circuit breaker. If a stock moves more than a certain amount in 30 seconds, electronic trading is temporarily suspended. The specialist manually picks the price of the next trade, and then electronic trading resumes. Since the price is chosen manually, it may take a minute or two for the specialist to place the trade. During this time, the NYSE publishes a "slow" quote.

When the NYSE is in "slow" mode, the fully electronic exchanges don't have to honor the NYSE's quote. They can trade at any price. If some program was pushing down the stock market, it would have completely ignored the NYSE, because the NYSE quote was in "slow" mode.

I didn't understand why the NASDAQ CEO was criticizing the NYSE for going into slow mode when the market suddenly tanked. The NYSE system was working exactly as intended. NASDAQ and the other exchanges will probably adopt a circuit-breaker system similar to the NYSE.

It seems that a error is responsible for the huge rapid drop. It probably was a combination of bad software, and a human error.

A lot of the trades will probably be canceled. That is potentially unfair. If you make a mistake, you should suffer the loss. If the policy is "such trades get canceled", then why would anyone bother to take proper precautions? I invested in Citigroup and Bank of America and lost money. How is that any different from a careless trader and lousy software?

Having a policy of canceling stupid trades encourages dishonest/incompetent behavior.

Regulators are saying "We can't figure out who was selling." That is nonsense. The exchanges have to keep track of the buyer and seller for each trade. They need that information to properly settle and clear the trade! It's a simple SQL query or Perl script to figure out "Who was selling during those 5 minutes."

It seems that regulators are covering up who was really selling when the market crashed. I don't believe that they can't figure it out. It probably was one bank or a small handful of banks responsible for the crash.

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