Saturday, May 8, 2010

The Market On Thursday: The Thousand-Point Bungee Jump

Just when you think that the markets couldn't get any
crazier, they continue to surprise us.

At 2:47 PM EDT on Thursday May 6, the financial
system's "autopilots" suddenly uncoupled and the
markets went into uninterrupted free-fall.

At 2;46 pm, the NYSE and the Dow were cruising along
to another down day in the markets, expecting a (-300)
down day. Profit-taking has been in order ever since
earnings week, and with declining volume, a mild
downtrend was expected. This was totally in line with
my own expectations as a trader, as declining volume
absent other considerations, usually means slightly
declining prices.

And I was expecting this. As a technical trader, I look
at the on-balance volume (advances vs. declines by volume),
in terms of support vs. resistance, comparing broad indexes
(SPY, $spx, $ndx) with trends of support and resistance for
the individual issues I cover. For you technicians out there,
it's a garden-variety OBV support-resistance model.

And I noticed one other thing. Tracing my stocks with
"candlestick charts", I noticed that the candlesticks
appeared to be growing long tails or downward wicks,
which tended to get longer as volume declined. So
I prepared. I stayed up until 2:00 am Thursday a.m.,
tweaking the model, closing out all my long positions
including the profitable ones, and loaded up "All Short"
for Thursday opening.

And at 11:48 am PDT, my patience was rewarded. Until then
most of my shorts were chugging along just fine, but some
had corrected slightly upside, putting me at a loss but not yet
hitting stops. And then - Free Fall!

at 2:48, the Dow dove fifty points. Then, a minute later, down
two hundred. Splitting screens to watch my stocks on one side
and the Dow on the other, I saw the Dow go into what can only
be described as a terminal-velocity dive, ultimately dropping
to 9869.62 - a drop of almost a thousand points in just seven

Then, matters began to correct themselves. The Dow then
jumped two hundred; then fifty, then up another hundred,
ultimately closing at 10, 520.32 - a drop of (341.90) for the
day, in line with my expectations.

But during that period, all hell broke loose over here.
Both my cell phone and landline were jammed with calls
from trading pals. Those who couldn't get through were
filling up my IM message box. One trading buddy from
California told me how he could not get through to
Scottrade either online or by phone and couldn't get
either his buy or sell orders executed.

And then, after the markets closed, the explanations
started to roll in. At first, attention centered on a
Citicorp prop trader on the CME who shorted 16 billion
S&P e-mini futures instead of 16 million. And I think that
that was highly unlikely. If you've ever been in a trading
room, traders have assigned stocks or other securities to
watch, with fixed position limits and other parameters.

A mistype like that would have been immediately flagged to
both a manager and a "floor walker" - a roving supervisor, who
would be at the trading station in an instant to ascertain what
was going on. So scratch that explanation.

Next, there was an explanation of a mismatch between
automated "bots" not being able to match buy and sell orders
due to mismatches between allowed position limits and
'circuit breaker" sets between the NYSE, Nasdaq, and the
many "private" off-exchange exchanges such as NYSE
Euronext, Nasdaq OMX (Off-Market eXchange), BATS,
Direct Access, Liquidnet, and others.

These exclusive exchanges, and the closely related
"dark pools" in which results are not forwarded to the
governing exchanges until the close of trading,
are nothing more than "high-limit" private gambling
rooms for the largest automated "algorithmic" traders.
The object with all of these "private" gaming floors
is to prevent "price discovery" and "national best
bid and offer" rules from taking effect and allowing
the ordinary trader or small investor to fairly

This is what makes "front-running", "flash trading "
"subpennying" and the other abuses possible. If
I'm a deep-pocketed "algo" shop with off-exchange
access, I can do this all day knowing that because
of my private access elsewhere, I can fade any
bid or offer you make and beat you every time.

And that's what I think happened Thursday.
Certain important components of the Dow, notably
P&G and 3M Corp, came under heavy selling pressure
at about 2:40 pm, most likely as a result of related
off-exchange moves in the futures markets.

As it was after 2:30 pm Eastern time, the circuit breakers
were off, and it would take human intervention to
halt trading, which happened - at least on the NYSE.

But that didn't halt the "bots" - the robot traders
on the "sell" side, who simply moved their action
in a nanosecond to the private exchanges and
continued selling.

However, the "buy" bots, electronically noting
the halt on the NYSE, refused to make bids.
Thus the selling pressure continued, with some
truly absurd results - Philip Morris, Accenture,
and Boston Beer (all NYSE) all saw their prices
prices drop literally to zero - until the "front-running"
subroutine kicked in to make a token one-cent "front-run"

However, once the bots were shut off and humans
intervened, things were, for the most part reset.
In the absence of circuit breakers, The NYSE and
Nasdaq are going to disallow trades that exceeded
a maximum 60% drop or rise from previously
allowed clearings.

But some of these extreme trades are going to be
allowed to go through - most notably some trades
by Goldman Sachs who shorted some issues all
the way down to a penny (at which they covered),
and then re-entered on the longside to take
advantage of the reset.

Reason? They all happened off-exchange - and the
"counterparties" were all other "big boys" who could
take the hit.

Just what you'd expect from a rigged casino - only
this time, it was the "Big Fish" who probably got
hurt most.

If that's true, couldn't happen to a nicer bunch.

But there's also another explanation other than
"algos gone wild", which has to do with politics.
At the same time all this was going on, the
Brown-Kaufman Amendment to the Financial
reform bill was being debated in the Senate, and
this would negatively impact the too-big to-fail,
too-powerful to-regulate crowd on Wall Street.

So the Street might have decided to send their
would-be masters in Washington a message -
Mess with us, and we'll give you a taste of what
we can do to you and the country in the markets.

That message got through - after the markets closed,
the Brown-Kaufman amendment was defeated 33-61.

Lesson for the day? This whole thing needs to be
restructured. New rules are needed - especially
new rules governing "High-Frequency Trading" ,
which as we now see, can as easily "evaporate"
liquidity as they provide it.

No responsible government can allow the markets - the
heart of what's left of the economy - to be held hostage
to the electronic equivalent of a Gulf oilwell blowout.

But until Washington gets some backbone nothing will
change, and nothing will be done.

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