Felix Salmon

How a market crashes

By Felix Salmon
May 6, 2010

How can the market go, on a random Thursday afternoon, completely insane? The story which is emerging centers on old, boring Procter & Gamble, as can be seen in the PG chart from this afternoon.

pgtips.tiff Look at the volume chart: what you see here is a big block of shares trading in P&G at around 2:30, followed by another huge block right before the market crashed. And then, nothing. The two big blocks were probably sell orders, which were big enough to blow through all the bids in the market. As Henry Blodget says, “for a few minutes, buyers just disappeared”.

It’s worth noting here that none of this data is particularly reliable: the Nasdaq is reportedly confirming that there were technical problems with the P&G quote, and there are persistent rumors of a “fat finger” trade as well, which I’m not sure that I believe.

If the market were rational, it could cope without difficulty with such things. There’s no bid on P&G right now? Fine, wait five minutes and see if you can get a bid then. But there were stop-loss orders on P&G, which meant forced selling into a no-bid market, and if these trades really happened, then a couple of people who are surely going to celebrate tonight were in the right place at the right time and bought up a small amount of the stock in the high 40s.

In any case, whether the trades actually happened or not, they were reported to the exchanges, and were immediately reflected in the Dow, which remember is an average and not an index. If P&G is off 14 points, and the Dow’s divisor is 0.132319125, then that one trade in itself wipes 100 points off the Dow in a matter of seconds.

The timing of that 100-point fall could not have been worse: stocks had started selling off about five minutes earlier, and so the 100-point drop came into a market which was already getting jittery and panicked. The velocity and severity of that drop in the Dow immediately triggered stop-loss selling in the market more generally, which then started feeding on itself: even as P&G’s share price was recovering, bids were falling away rapidly in the other 29 Dow components, and at one point the Dow was down just a hair short of 1,000 points on the day.

But the fact is that none of these numbers are all that meaningful: what we were seeing was traders flailing around in a context of limited information and liquidity, trying to get a grip on what was or wasn’t going on. There was always the possibility, after all, that the sellers knew something they didn’t, and that stocks were actually falling for a reason. So it took a few minutes for the market to realize that it was all just market volatility — and therefore a great buying opportunity for any trader.

It’s been a very impressive day to learn how the stock-market sausage is made: I think we just saw the largest intraday fall, in point terms, that has ever happened. But the bigger lesson is that in the short term, any market can fail temporarily. The question is whether the jitters from this afternoon are going to mean increased volatility and risk aversion going forwards. My feeling is that, yes, they both will and should.

23 comments so far | RSS Comments RSS

If there were no more offers, wouldn’t the market-makers be forced to step in and, you know, make a market?

Posted by Sportello | Report as abusive

No informed opinion on this, but are traders really bouncing their buys / sells off of what the dow is doing as a whole? I would figure that using the SandP or some other broader market would make more sense (in general, and in this case in particular)

Posted by djiddish98 | Report as abusive

Sorry, but how could fat fingers destroy $1.25 tillion in market value as Bloomberg is reporting?

Posted by NoDiv4 | Report as abusive

ok. So the “average Joes” got screwed on their simple Stop-loss orders.

How did the Vampire Squid’s HFT-Bots fare in the swift rebound?

Up or Down. I’d like to see numbers.

Posted by bryanX | Report as abusive

I’m assuming Felix meant that fat fingers caused a wrong sell order that triggered the panic that followed. (That’s the rumor I’m hearing, i.e. an order went through that was accidentally keyed at 1000x the correct sizing.)

Posted by fixedincome | Report as abusive

Disclaimer: I am not a trader and I may be only familiar with trading software in general, not with this particular exchange.

Either the time axes for price and volume are not aligned or the market picture shows a clear pattern of short selling followed by buying back shares covering the short. The first spike in volume precedes the collapse in price. Someone sold about 1 mln shared at $62. The second one happened after a decline in prices. The dramatic decline in prices formed because of the reaction of other traders to the first big trade. Then after the market started bouncing back somebody (the same trader?) bought over 1 mln shares at less than $61, thus making over $1mln in less than 15 minutes (minus the cost of borrowing shares) – if my hypothestis is true. (look at the price movements they suggest the directions of the leading trades). I cannot see any abnormality on the graph and to me this does not look like an error as someone made money on the trade. The circuit breakers were not activated.
http://www.nasdaq.com/aspx/stock-market- news-story.aspx?storyid=201005061518dowj onesdjonline000817&title=stock-market-tu mble-not-enough-to-trigger-nyse-circuit- breaker

I may have a suspition that more money might have been made on the index and other shares if the timing of this short was known in advance. So who lost? Most likely super funds and market minnows.

Why did the market seize? Because most of the trading occurs between automated trading applications (algorithmic traders) which have discovered a pattern leading to covering loses – they not only monitor price but also the volume. The initial decline in price wasn’t significant and in my opinion didn’t trigger stop or stop-limit orders.
http://answers.nasdaq.com/questions/deta il/20090547f697a/how-does-a-stop-limit-o rder-work
Only when human traders stepped in the price started recovering – this should explain the delay. Somebody who placed the first block of trades must have anticipated this market behaviour in advance. I would not be surprised if these guys have quite accurate dynamic models of the market – otherwise why would investment banks recruit the best physicists and mathematicians?

http://www.ifaamas.org/Proceedings/aamas 09/pdf/02_Extended_Abstract/E_SP_0406.pd f

Posted by adam007 | Report as abusive

The curious thing about today’s events is not that the market moved abruptly and discontinously, but that there are people who are still surprised that markets can move unpredictably. It’s what markets have always done and will always do, whether in response to events, computer errors, human errors, HFT, or simple gambling impulses. If you don’t like it, don’t trade.

Market makers do not have to make a 1-cent spread, low volatility, high liquidity market in all assets at all times. They do so under lots of conditions because their execution, funding and volume are good enough that it’s typically profitable for them to do so. At some times, shocks blow out spreads and liquidity dries up. Options spreads on usually fairly liquid options that I watch were insane today for a while – stuff like 2.80 bid/3.50 ask on large cap US stocks. It happens. You can still DCA into stocks you like and avoid leaving limit orders and you never have to sell in a crash.

Posted by najdorf | Report as abusive

It looks that a lot of activity occurred on the future markets around that time but I would be surprised if there was an error.

You don’t make errors on which you make so much money and human traders have risk limits sets in their trading applications. If you had entered an incorrect quantity the trade would have been rejected.

So I don’t believe in the story from:

P&G wasn’t overly shorted. It was just the timing.
http://shortsqueeze.com/shortinterest/st ock/PG.htm

We may need a few more days for a more thorough analysis.
Anyway, time to go to work…

Posted by adam007 | Report as abusive

Why did Nasdaq cancel trades?

Posted by jomiku | Report as abusive

My problem with the fat finger theory, assuming that a trader did indeed send out an order for billion shares instead of million, does P&G even have that many shares outstanding, or the order just scooped up all the shares available in the account or available to be borrowed (in case of short sale)? seems like just some error on the tech side to me

Posted by sedrak | Report as abusive

Felix’s article this morning about investing retirement funds in TIPS instead of equities could not be more prescient…

http://blogs.reuters.com/felix-salmon/20 10/05/06/why-invest-retirement-funds-in- stocks/

Posted by MarkC123 | Report as abusive

I think the market is unstable at best. The market people may have to outlaw automatic sell or buy triggers to put stability into the market. Otherwise you will see investors departing in droves and the traders can keep playing there little games for each other.

Posted by fred5407 | Report as abusive

The 16 billion DOLLAR VALUE trade was in the ES. The mistake was 100 fold. If you were watching the DOM at that time (and your charts didn’t stop)you saw super thin market and as the futures dropped, all the linked trading cascaded things lower.

On the so-called “glitch” trades like Accenture, look at any Level 2 bid/ask and you will see resting orders at the extremes. If some dummy has a stop market order hit and everyone backs away (like the goobers at the NYSE did) the electronic market is all that is left and if 1 cent is the best BID, that is the market price that is filled. Any REAL market maker would have stepped up and bought Accenture at a dollar or ten, if they had not been asleep at the wheel. Same with PG. What knowledgible MM would let it trade to $40? What a joke.

If you don’t know how to drive a car, stay off the road. If you don’t know how to enter a stop limit order or understand how electronic trading works don’t do it.

The real crooks are those like GS, C, BAC, etc etc that manipulate the market with the Fed and govt’s assistance.

You are sadly mistaken if you think the game isn’t rigged.

Posted by butopia | Report as abusive

I’m wondering why everyone is focusing on PG and ignoring the really weird trades in Accenture, Exelon, a whole bunch of Vanguard ETFs, all of which traded down to zero?

Posted by niveditas | Report as abusive

My investment strategy has changed. There is absolutely no way I can cope with this grand casino. I am buying 5 $1.00 lottery tickets each week. At $260 per year it will be less costly and incredibly more sane.

Posted by usaf7209 | Report as abusive

I am glad that blame is being placed where it belongs, on algorithmic trading.

High frequency trading makes up 75% of volume and serves no other purpose than to find the other side’s limit price and eat up the difference.

http://market-ticker.denninger.net/archi ves/1259-High-Frequency-Trading-Is-A-Sca m.html

It is a fraud and a major reason why traders like Blankfein, in charge of this manipulation, really ought to be in orange jumpsuits.

High frequency trading serves no meaningful purpose and the suggestion of a tiny transaction tax is right on. High frequency trading, as we have seen is not real liquidity but make-believe liquidity that vanishes when we need it most.

The unfortunate thing is that as a result of this, more people will try to do limit orders, which are just what high frequency algorithms need to skim the difference. Market orders won’t do. Thankfully for Goldman Sachs and others, high frequency trading fraud is about to become even more profitable.

Posted by DanHess | Report as abusive

This is no techinical failure as the stock market people are tring to make us belivie , this is a money laudering operation, someone with “cold” money or money that he cannot lawfully declare, lets say drug delaing money, he makes the sell pg at 62 and the buy at 49 and the other partner of the operation lets say a stock fund buys at 32 and send at 49 in a daytrade , the fund gets the loss the traficant send the “cold” money to the inescrupulous fund manager, the huge and almost equal volume of the these orders says so and i susgest IRS and SEC perople shouls examin very weel all the participants of this operation

Posted by andy_c_m | Report as abusive

HFT, Program Trading, Proprietary Trading, etc. have literally taken over the financial markets. Why? Basically because of the US tax rates.

Think about it. In the 1970s the US experienced the most consequential change in its modern political and economic status: the oil embargo. Cheap fuel, the basis of the much of the US economic boom since WWII, was over and so was the US political clout. It had a major Achilles heel with no remedy. The equity markets did sell off hugely as to be expected. However, not a single major bank or brokerage firm failed. No bail outs, no Fed intervention, etc. Why? Because speculative trading, both in derivative and program trading, was for the most part non-existent.

Fast forward to 1986 post Reagan tax cuts and new Fed chairman: short term cap gains tax dropped from 70% to 35%. Only 15% points higher than long term cap gains tax rates. Plus derivative income tax rate on options of broad based indices went down to 10%. Greenspan pushed for deregulation and easy credit through low margin requirements. No wonder derivative business and hedge fund trading boomed. Now we see the consequences.

Main Street investors are now absolutely scared to go into US equity markets. Even knowledgeable Wall Street veterans realize that one of the bases of capitalism, long term equity investment, has been replaced by short term traders.

Unless the US changes its tax code (tax s/t gains and derivative trades at 80%), the boom/bust destruction will continue.

Posted by Acetracy | Report as abusive

To invest, you have to put up cash – to short, nothing. Obviously there is a ton of whatever out there – waiting to short.
Make them put up cash to short and see how things change -

Posted by dicryan | Report as abusive

@dicryan That would probably be a more compelling point if it were actually true. Retail customers typically have to post collateral worth more than the value of the stock being shorted, and typically earn no interest on it (or, if they borrow the cash to post as collateral, they pay the same call rate as they would for a long position done similarly on margin); while the obligations for institutional investors are different, they are typically parallel, with an ability to buy or sell by putting up some amount of collateral that usually is a slightly greater disadvantage to the short side than the long.

Posted by dWj | Report as abusive

Anybody that thinks this was a mistake from some trader hitting the wrong key, should ask why the SEC allowed some trades up to 60 to go threw. while others were not.

This was not a mistake. the world economy is in a state of deflation. I found it strange they passed a bailout for 1 trillion for the EU, in just one weekend. had they not done this. the markets would have gone further down on Mondays opening trade.

All the bailout money in the world is not going to stop it either. they are just prolonging the painful truth that distressed companies need to fail. the world is at over capacity from to many cheap goods. interest rates at zero, index is rising and to many banks with unknown debt they hold. if the mark to market rule was to take affect right now. banks would fail right and left from the sheer weight of the credit default swaps, and housing market prices falling into the lower and upper 40% range.

The ride is just beginning. so put on your seatbelt, strap in, and watch the show. cause your fixing to see what happens with government bailout’s, and entitlement spending out passes revenue growth.

You have a nice day now.

Posted by Macwizz | Report as abusive

The stock market business is a bustling arena of trading stocks. It is an amazing area to learn about business rise and fall and by spending time observing you can see how something like this can occur. The monitoring of the specific stock changes will tell the story of what went on for this short moment the 5th or 6th May. There are many programs available to ensure you are abreast of falling and rising shares. It appears at this time, stock investors pulled their money, this then created the flood of selling shares and reentry soon after. The graph is a great snap shot. – http://www.cifgltd.com

Posted by M.Kingsley | Report as abusive

The stock market crash on Thursday afternoon took financial Web sites down with it, as people hurried online to make trades and check their investments. Yahoo Finance, Fidelity.com, and Google Finance are among the sites that people complained were unavailable or slow for a period during the afternoon. This has definitely affected the e-commerce marketplace, which has become the virtual main street of the world. Providing a quick and convenient way of exchanging goods and services both regionally and globally, e-commerce has boomed. The stock market crash has caused much volatility in the marketplace.


Posted by AlbertSparks | Report as abusive

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