Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Will You Make Money in the New Silver Bull Market ? - 13th Aug 20
Hyper-Deflation Capital Destruction And Gold & Silver - 13th Aug 20
Stock Market Correction Approaching - 13th Aug 20
Silver Took the Stairs to $21 in 2008, Took Escalator to $29 2010. Is Silver on Elevator to 120th floor today? - 13th Aug 20
President Trump Signs Additional COVID Relief – What To Expect from the Markets - 13th Aug 20
Has Gold's Upward Drive Come to an End? - 13th Aug 20
YouTuber Ads Revenue & How to Start a Career on YouTube - 13th Aug 20
Silver Notches Best Month Since 1979 - 12th Aug 20
Silver Shorts Get Squeezed Hard… What’s Next? - 12th Aug 20
A Tale of Two Precious Metal Bulls - 12th Aug 20
Stock Market Melt-Up Continues While Precious Metals Warn of Risks - 12th Aug 20
How Does the Gold Fit the Corona World? - 12th Aug 20
3 (free) ways to ride next big wave in EURUSD, USDJPY, gold, silver and more - 12th Aug 20
A Simple Way to Preserve Your Wealth Amid Uncertainty - 11th Aug 20
Precious Metals Complex Impulse Move : Where Is next Resistance? - 11th Aug 20
Gold Miners Junior Stcks Buying Spree - 11th Aug 20
Has the Fed Let the Inflation Genie Out of the Bottle? - 10th Aug 20
The Strange Food Trend That’s Making Investors Rich - 10th Aug 20
Supply & Demand For Money – The End of Inflation? - 10th Aug 20
Revisiting Our Silver and Gold Predictions – Get Ready For Higher Prices - 10th Aug 20
Storm Clouds Are Gathering for a Major Stock and Commodity Markets Downturn - 10th Aug 20
A 90-Year-Old Stock Market Investment Insight That's Relevant in 2020 - 10th Aug 20
Debt and Dollar Collapse Leading to Potential Stock Market Melt-Up, - 10th Aug 20
Coronavirus: UK Parents Demand ALL Schools OPEN September, 7 Million Children Abandoned by Teachers - 9th Aug 20
Computer GPU Fans Not Spinning Quick FIX - Sticky Fans Solution - 9th Aug 20
Find the Best Speech Converter for You - 9th Aug 20
Silver Bull Market Update - 7th Aug 20
This Inflation-Adjusted Silver Chart Tells An Interesting Story - 7th Aug 20
The Great American Housing Boom Has Begun - 7th Aug 20
NATURAL GAS BEGINS UPSIDE BREAKOUT MOVE - 7th Aug 20
Know About Lotteries With The Best Odds Of Winning - 7th Aug 20
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
ARE YOU LOVING YOUR SERVITUDE? - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Protect Yourself from the Next Stock Market "Flash Crash

Stock-Markets / Financial Crash May 19, 2010 - 05:12 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleShah Gilani writes: Just when you thought it was safe to get back into U.S. stocks, you think you see a shark.

If you are searching - like the regulatory lifeguards and all the political beach bums - to pinpoint and kill the menacing shark that took a huge bite out of investor confidence when the Dow Jones Industrial Average tanked 1,000 points in a just a few minutes late in the day on May 6, don't bother to scan the horizon looking for the dorsal fin of some lurking predator.


The threat you fear isn't under the water: It is the water.

We're talking about market liquidity.

Investors who wish to understand the cause of the stock market flash crash must first understand the nuances of stock-market liquidity. For purposes of this discussion, we'll define liquidity as "an asset's ability to be sold without causing a significant movement in its price and with minimum loss of value." In other words, that liquidity is the fluid that floats fair and orderly markets.

Unfortunately, market liquidity has been evaporating under the heat of trading venue competition.

That's one key reason that investors should be scared about being in the markets. But it's not the only one. To understand the potential current market pitfalls - and the steps investors can take to avoid them - we're going to take a look at:

•The truth about what caused the flash crash.
•What should - but won't be - done in response.
•And what you need to know to protect your portfolio.
Let's start by rounding up all the usual suspects - the high-frequency traders, the hedge funds, the prop-trading desks, the derivatives traders, Goldman Sachs Group Inc. (NYSE: GS), the U.S. Federal Reserve, and Satan - even though that's an exercise that won't yield any confessions or get you any closer to the truth.

Maybe one of them lit the fuse; maybe all of them - collectively - are to blame. Although it's good sport - and not necessarily wrong - to point fingers at any of these market movers, doing so misses the underlying fact that the problem investors face is systemic.

The factors that led to the stock market flash crash are actually the unintended consequences that can result when you promote competition.

(Un) Making a Market
Back in 1975, the cozy world of fixed commissions on stock trades ended forever. The resultant competitive push to execute trades at increasingly reduced costs eventually morphed into the never-stand-pat world of computerized trading, and what were once fair-and-orderly markets devolved into chaos.

In the quaint old world of Wall Street, which revolved around the New York Stock Exchange (which is actually on Broad Street), brokers funneled all their customers' orders to buy and sell stocks to "the Exchange.'

At the NYSE (NYSE: NYX), later known as "The Big Board," all the orders went to a "specialist" whose job was (and still is) to keep a "fair and orderly market" while executing all the trades in the stocks for which he is the specialist. To make sure he had a record of all "Buy" and "Sell" orders, he wrote them down in a big leather book.

The "book" had the names of the brokers (only brokers can send orders to the Exchange) who sent down orders along with the number of shares and the prices at which customers wanted to buy and sell the stock. The specialist was responsible for keeping the book and making a market, meaning showing the public what the "bid" was (the highest price someone was willing to pay) and how much stock was being bid for, and what the "offer" was (the lowest price someone was willing to sell at) and how much stock was being offered at that price. The process is called "keeping a book," or "making a market."

When a buyer wants to pay the price a seller is offering to sell at, or when a seller wants to sell at a price a buyer is willing to pay, a trade occurs. That trade is then transmitted to the "tape" (which used to be a long running, thin ticker tape but is now electronically transmitted) to be displayed for the entire world to see.

What's important about the old system is that there was only one specialist per one stock and all orders to buy and sell that stock went into his book. The book was said to be "deep" if there were lots of standing orders waiting to be executed when customers' price objectives were met.

Besides matching "Buy" and "Sell" orders, the specialist can trade the stock for himself. In fact, if there aren't enough public orders to keep the stock trading in an orderly fashion, the specialist is required to trade the stock (make bids and offers) to keep a "fair and orderly market" - regardless of whether the stock is headed up or down, and regardless of how fast it's moving.

From One to Many
Then along came the competition. Other exchanges began to spring up to trade new stocks that were being offered to the public. The American Stock Exchange (AMEX), the Boston, the Philadelphia, the Pacific and others sprang up. Then the electronic age yielded the NASDAQ (National Association of Securities Dealers Automated Quotations), where there wasn't a single specialist in charge of any one stock, but several "market-makers" - each of them acting like mini-specialists, and each making a market in the same stocks.

After fixed commissions were done away with in 1975 and greater competition was encouraged, it was only a matter of time and innovation before new trading facilities sprang up. However, these newcomers didn't want to trade new stocks, they wanted to trade the same stocks that were once the exclusive provinces of the physical exchanges - the NYSE, the AMEX and the Nasdaq. And these newcomers wanted customers to be able to place orders directly, bypassing brokers altogether.

Now we've got physical and electronic exchanges trading each others' stocks, "upstairs" block trading desks, private crossing networks (Instinet, the original "private" exchange established in 1969), electronic communications networks (ECNs) that allow direct access to execute posted bids and offers, ECNs such as BATS Global Markets that have become their own exchange, internal broker-dealer matching facilities, and what's infamously known as "dark pools," where big mucky-muck dealers like Credit Suisse Group AG (NYSE ADR: CS), Goldman Sachs and Knight Capital Group (Nasdaq: NITE) cater to institutional behemoths who don't want to mix their sizeable orders with the little people.

Anatomy of a Downdraft
When it comes to the stock market flash crash, the bottom line is that the new "system" has too many moving parts and no funnel to facilitate a singular, deep "book" of orders to ensure a fair and orderly market.

Precisely because there are so many competitive trading venues, orders are actually split up for reasons that include:

•Blind execution (not wanting anyone to know who is trading how much of what).
•Payment for order flow (getting paid to send orders down to different exchanges or venues to create liquidity because they don't have enough).
•And, of course, because of the costs, cronyism, and the clout that comes with extravagantly entertaining clients to get them to trade through self-serving systems.
The professionals aren't stupid. They know that markets aren't deep, so they don't put down big orders. In just the past few years, the average NYSE trade has dropped from 1,600 shares to about 300 shares per trade. According to Tabb Group, a New York consultancy, 10%-12% of stock trading volume is executed (and not counted) on some 40 dark pools.

It doesn't matter if a fat-fingered mistake sent a giant order down to an exchange by mistake, or if a big options order caused some index to tank, or that panic over Greece sent stocks lower and the NYSE had circuit breakers that other exchanges didn't have. Nor will it matter if new rules make other exchanges incorporate all the same "liquidity replenishment points" (or circuit breakers) that the Big Board uses.

Liquidity evaporated on the NYSE and trades rolled over to other exchanges, and guess what? Because there was panic all around, bids evaporated as traders cancelled them, there is no depth in any venue's "book" for any stock, and the liquidity that high-frequency traders are supposed to provide (their HFT arbitrage and algorithmic trading models generate anywhere from 50% to 70% of daily trading volume, which absolutely helps create liquidity in normally functioning markets) evaporated as they shut down operations, afraid that their computers would blow them up with losses.

That's the truth.

It's a systemic problem that can't be easily solved because none of the players in the trading-venue business want to be disadvantaged by giving up any edge they have or are seeking to profit by.

Solutions and Caveats
If the investing public were to fully understand just how "thin" these markets actually are - and how 'at-risk their orders are - they are going to remain on the sidelines and the markets will be even more dangerous for all of us who are in them with our pension money, IRAs, mutual funds, or other hopes we have for a reasonable return on our equity investments.

What's worse is that we desperately need those robust returns from stocks in order to offset the piddling interest payments that we'll receive on our fixed-income investments, thanks to the too-big-to-fail bankers who busted the economy so badly the Fed has to have a zero-interest-rate policy so the same bankers can rebuild their balance sheets and bonus pools by re-leveraging themselves on taxpayers' backs.

The only fix is to make all venues post all their bids and offers into a central "book" to provide necessary depth and liquidity to make markets fair and orderly again. There are ways to identify whose orders are adding to liquidity, ways to compensate orders differently, and ways to keep the system both blind enough and transparent enough for everyone to be safe. But, as usual, the greed of the few (who have the political muscle and money) will have to be throttled to make the track safe for all investors to get to the finish line.

Until that happens, ask for written "best practices" from your brokerage or trading venue on how they execute trades. Demand to know what circuit breakers, failsafes and other protective measures are in place to protect you. Ask about what happened to market orders they executed during the flash crash: Did they get cancelled outright, or were they erroneously executed as a result of that late-day nosedive? And lastly, if disputes arose, how were they settled?

The bottom line: Find out what rights you have, and get those guarantees in writing.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When the May 6 downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. As of Friday morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

Source : http://moneymorning.com/2010/05/19/flash-crash-3/

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules