Market Cascade

Afterward, rumors flew about the source of the problem. Some said a trader had punched in a billion when intending to enter a trade in the millions. But trading systems typically have built-in checks to prevent such an occurrence, so I doubt this explanation holds water.

Whatever the cause is determined to be, what we witnessed in the Flash Crash was a market cascade. To understand how such a cascade works, we must first understand the auction system by which most stock transactions take place.

All stock orders to buy or sell fall into one of two fundamental categories: “market” or “limit.” In a market sell order, the owner of shares tells the exchange that he or she will sell a given quantity of shares, say IBM, at the best available price. In a limit sell order, in contrast, the owner says he or she will sell up to the specified number of shares to the first buyer who will offer a specified price.

The typical investor assumes a stock is worth the last price at which it traded. Wrong. A stock is worth only what the next buyer is willing to pay for it.

At any given time, a series of bids by prospective buyers for any given stock exists. Let’s look at a typical bid pattern for IBM, where the last trade took place at $120 per share:

Note that the bids are prioritized by price. If you place a market order to sell 100 shares of IBM, you’ll receive $119.99 for each share. However, if you place a market order to sell 1,000 shares, only your first 100 shares will fetch $119.99; for the next 200, you’ll receive only $119.98 a share, and so on down the bid priority list until you reach the $119.22 bid for your last 300 shares. IBM now shows a last trade at 119.22, a quick drop of $0.80 from the previous last trade reported.

At all times, there are a lot of traders watching what’s going on, many of them using computerized trading systems looking for any market angle. One might interpret the sudden drop as signal to sell IBM and instantly enter a market order to sell another 1,000 shares of IBM. Unless the bids have been refreshed by interested purchasers, the sixth bid in our example would be the first to be executed, covering the first 100 shares. The last 400 of the second order would go to the ninth bidder at $107.25 per share, a good-until-canceled limit order placed weeks or months before.

Many investors use a type of order known as a “stop-loss” in the belief this will protect their profits in a stock. Say you bought 500 shares of IBM at $75 each, and when it went to $100, you put in a stop-loss order at $90, 10 percent below the market. As IBM climbed, you moved the stop higher. When IBM reached $120, you moved your stop up to $108. This popular strategy, known as a “trailing stop,” is a prescription for disaster. Many investors don’t realize that a stop-loss order automatically becomes a market order when the stop price is reached.

Unwittingly, you’ve become part of the cascade, as your stop-loss order becomes an immediately executable market order to sell 500 shares, and the only available bid is another low-ball, good-until-cancelled order, this time at $65 per share. Your order is executed and your loss of $10 per share becomes real, even though IBM might recover most or all of the drop minutes later.

Now the whole world sees that IBM last traded at $65 a share. If a strong company like IBM has suddenly lost 45 percent of its value, what about those thousands of other stocks of lesser-known, financially weaker firms? The rout is on. And note that, unless other bidders again have come into the market, there’s no bid for the next IBM seller. In other words, IBM stock is—at least temporarily—worthless.

Of course, in the real world, there are thousands of bidders, not 10, for IBM. But the difference between the real world and my simple example is only one of degree. At the time of the Flash Crash, some stocks did run through all the outstanding bids, generating reported trades at pennies per share.

In the aftermath, the New York Stock Exchange and the NASDAQ cancelled many of the trades that took place at extremely low prices. This remedy may actually make the problem worse next time, because willing buyers may not be so willing to submit orders if they don’t think they’ll be able to keep their gains.

Before the advent of computerized trading, a critical component of the New York Stock Exchange was floor traders known as specialists, whose job was to maintain a “fair and orderly market.” These specialists are now relics of the past. While the NYSE and NASDAQ can (and did) shut down trading during the Flash Crash, the majority of stock trades now occurs among high-frequency traders on private exchanges whose activities have little or no coordination with the traditional stock exchanges.

It won’t take many more Flash Crashes for investors to distrust the market altogether. Should that occur, it’s Katie-bar-the-door to the downside. The SEC and stock exchanges need to immediately address the serious lack of a fair and orderly market exposed by the events of May 6.