Quantum Physics, Flash Crashes And Market Illusions

Mar.23.12 | About: Apple Inc. (AAPL)

First off, I think we have to stop calling every single market irregularity a "flash crash," like what happened to Apple (NASDAQ:AAPL) on Friday morning when liquidity dried up and the "price" was around $542.

We tend to think of the stock market in a "wave" like fashion. Prices may move up or down rapidly, but there's an orderly sequence to what amounts to what seems like an ongoing auction throughout the day.

But that's just an illusion.

It kind of reminds me of quantum physics. It's probably most convenient for us to think of light as a wave - great if you want to measure stuff like wavelengths.

Yet light also behaves like a discrete set of particles, photons they call them. And you don't really know what form light will take until you measure it. And the very act of measuring a really tiny particle can actually effect the particle itself. Physicist Werner Heisenberg called in the "uncertainty principle."

So basically, at the subatomic level, much of the reality we take for granted is more of a probability distribution than anything else. An electron will "probably" be at a certain location, but we can't be precise. And there's a small chance that electron could be nowhere near we think it "should" be.

Usually we don't care. After all, we don't need to know exactly where an electron is to benefit from, say, electricity.

So what does this have to do with Apple?

Simply this: It's an illusion that there exists at any specific time and place any specific price for Apple. Let's say that post-market trading has concluded. Does Apple have a price? Perhaps in overseas markets later in the evening, but until then it does not exist.

So at any given time, Apple's "market price" is more of a probability distribution than anything else. Usually, it's so close to the last trade that we don't care.

But in an age of high-frequency trading, you simply can't count on any stock behaving like a wave function, rising and falling in measured doses. Back in the days when stocks traded on exchange floors, specialists could mostly manage price changes to maintain some order, but those days are long gone.

Now you have to think of any stock like you might think of your house. Sure, your house has an appraised value. It also probably has a price where you'd get an almost immediate offer. But the price you could sell it for "right now"? It doesn't exist.

If you count on orderly markets, you'll usually be OK - but not always. With bids and offers being submitted and withdrawn in milliseconds by computers, there's no way to say that Apple or any stock has a "real" price at any given time.

Long-term investors don't care if a stock has a momentarily non-existent price at any specific time. But more investors use stop orders these days and that can be frustrating. That's why I think using put options makes more sense than stops.

Events like Apple's temporarily non-existent price leave me longing at least a little bit for the old stock market specialist. He could generally coax a few bids or offers out of the traders near his post when he needed to. Not always, but he could often be persuasive.

But today the old "c'mon I need a bid" plea goes unanswered by the computers that drive today's markets.

You have two choices. You can fool yourself by thinking the market is orderly when it's not, nor even necessarily should be. Or you can face the facts that events like Friday's will happen from time to time and plan accordingly.

Disclosure: I am long AAPL.