Friday, May 7, 2010
The bars were busy last night.
Traders all over the country – from San Francisco to Manhattan – sought comfort at the bottom of a highball glass. Action like we saw yesterday will do that. No matter whether you were bullish or bearish heading into the day, odds are pretty good you got worked over.
The problem started at about 2:35 p.m. The Dow was down about 300 points. The bears were firmly in control, but it was a steady decline – not an emotional panic. Stocks were so oversold, a brief snapback rally appeared likely.
For about five minutes, anyway. Then the wheels came off.
At 2:41 p.m. stocks started to crash. By 2:47, the Dow was down 1,000 points. The S&P 500 was trading below my 1,080 downside target for this correction phase – which I wrote about here. It felt like a panic. So I started looking for something to buy.
I looked into the option markets, and couldn't believe what I was seeing. The bid/ask spreads – the difference between what you have to pay to buy an option and what you get to sell it – were 200% or more. In other words, an option that might cost you $3 to buy was only worth $1 if you sold it.
Liquidity had dried up. None of the option market-makers were willing to trade for anything close to a reasonable and fair price. If you wanted to buy options, you were going to have to pay up for them. And if you wanted to sell options, you'd have to do so at a steep discount.
You'd think anyone who owned puts going into this massive 1,000-point decline would have made a fortune. But they couldn't get out of their positions. There was no one around to take the other side of the trade.
It was a similar problem for anyone wanting to buy call options. And the same thing was happening in the stock market. Bid/ask spreads – which for most stocks are just a penny or two – were $1 or more.
You can't really do much trading in that situation. If we can't have faith in a fair market, who wants to play the game?
By 3:00, the Dow was down "only" 500 points and the S&P was back above 1,120 – some 50 points off of its low. The folks at CNBC were speculating this crazy action was the result of a "fat finger" trade – where somebody sitting at an order desk somewhere hits one too many numbers on his keyboard, thereby selling exponentially more stock than he had planned to.
I don't buy it. This wasn't a trading error caused by somebody's chubby fingers hitting the wrong keys. Maybe there was a human trading error, maybe even two or three of them. But that doesn't account for the entire stock market getting flushed down the toilet.
This was a complete dry-up of liquidity. Too many computers programmed to sell out at the exact same level, and nobody around to take the other side of the trades.
What we saw yesterday was the downside of the high-frequency trading (HFT) and the algorithmic program trading that has kept the market so lopsided to the upside over the past several months. It's a little taste of what happens when those programs start to reverse. Nobody seems to mind a little computer-generated market manipulation when stock prices are going up. I'm guessing most people feel a little different about it today.
Much like the stock market crash in 1987 brought attention to the side effects of program trading and portfolio insurance, yesterday's action should shine a similar spotlight on algorithmic trading.
It's about time.
Best regards and good trading,
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