One Theory About What Happened in Thursday's Market

 |  Includes: ACN, DIA, PG, QQQ, SPY
by: David White

Accenture (NYSE:ACN) went to $.01. PG went far down into the $40’s. What happened? Some said it was a glitch. Some said it was HFT. Possibly some glitch that played a part, but a more likely explanation is that William J. O’Neil has a lot of adherents among retail investors. He advocates selling when stocks fall 8% from their tops. The modern day retail investor can set trailing stops at 8% that will move up as the stock moves up. Then they think they can safely ignore their stocks. The 8% stops protect them to the downside (or so they think). Most of these retail traders set “at the market stops” because they don’t want to take a chance that they will miss selling their stock in a downturn. We had a big down day Tuesday. We had a down day Wednesday. Then at some point Thursday a lot of stocks started triggering their 8% stops. When this happened it caused a cascade effect.

With many stops triggered, but few buyers in the short term, the bids for many stocks plummeted. When enough of the stocks in the SPY, the QQQQ, and the DIA, etc. exhibited this behavior, the stops for these indices started to get triggered. When the indices (SPY, DIA, QQQQ) were then sold, the individual stocks in those indices were then sold by the ETFs. This caused even more of the stocks in the indices to hit their stops, and VOILA, the entire market plummeted out of control. At some point in this process, the NYSE "slowed down the process" to better assess what was happening. Apparently this only served to make stocks fall faster on other exchanges. Still, if more of these people had used limit stops, this situation might well have been avoided. However, few people have strong faith in the market after what has happened in the last two years. Their fear makes them use “at the market stops”. Their fear likely cost them a lot of money yesterday. I note many sectors finished down more than 10% from their recent highs.

Some have said that HFT was at fault. It is possible, but the reality is that most brokerages do not use HFT to drive the market downward because they do not want the adverse publicity. What is more likely is that HFT traders turned off their programs, which usually pushes the market to the up side, in order to avoid losses. This caused a problem because the liquidity was no longer there. This meant that bid prices could fall quickly and dramatically. They did.

Of course, HFT traders started to turn their programs back on when they realized people would soon be bargain hunting. I am sure most made tons of money quickly as the market quickly pushed back up hundreds of points. What is the solution to all of this? Frankly, I couldn’t come up with an easy one off the top of my head. Still it does make one a little sick that the retail investors got taken to the cleaners, while the HFT traders made big money on the way back up. There’s a scam in there somewhere.

My own opinion, as those who follow my blogging know, is that a retracement has been overdue for some time this spring. I believe the HFT traders have caused a slow “melt upward” as Bob Pisani of CNBC has labeled the steady grind of the market upward since Feb. HFT trading often accounted for 80+% of the trading volume, so it was easy to do. Then they simply turned their programs off when the global events made a turn downward too likely. This left the retail investor to take the loss generated by the HFT traders making the profits on the slow “melt upward”. Plus, to top it off the HFT traders got to make more money on the way back up after the market overshot to the downside due to the huge triggering of automated market stop orders. There does seem to be something ethically wrong with this.

As for the market direction, the pundits are saying it is likely that the markets will back fill the rebound upward engineered by HFT Thursday. Two big events today are the jobs number and the German parliament vote on the Greek bailout package. If a lot of people react to the down movement belatedly this morning, one might expect the markets to open downward. If the economic news is okay though, they might rebound upward (at least temporarily). Since the jobs number is revealed early, it seems likely that the markets would trigger any up move on an approval of the Greek bailout by the German parliament.

Good luck trading.

Disclosure: No positions at this time