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.


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