The Latest Trading Glitch Sending Mr. Market on a Wild Ride

Remember that crazy "flash crash" of 2010? It's baaaack!

Thanks to trading firm Knight Capital (NYSE: KCG  ) , today we were treated to a showing of "Flash Crash II: The Revenge." NYSE Euronext was reviewing the trades of 148 companies -- including Alcatel-Lucent (NYSE: ALU  ) , SandRidge Energy (NYSE: SD  ) , Molycorp (NYSE: MCP  ) , and Annaly Capital Management (NYSE: NLY  ) -- after odd trading activity.

Molycorp shares, for instance, plunged 17% while trading reached 8.6 million shares as of this writing. Molycorp's average daily trading volume has been 2.7 million shares, and the company did not release any substantive news today. Similarly, shares of Alcatel-Lucent were swinging wildly on heavy volume this morning on no news.

This flash-crash-esque screw-up didn't pack nearly as big a punch as the original, which sent some shares plummeting all the way to $0.01 and dragged down the entire market. But the reaction has been just as overblown.

Oh, the humanity!
As machines took another opportunity to remind us that they're not perfect -- particularly as long as they have to be programmed by humans -- many market commentators took this opportunity to remind us just how shaken individual investors are and lament that this will only exacerbate that.

The Wall Street Journal noted that the issue was "raising concerns that another technology problem may dent investor confidence." The Financial Times went further (free registration required):

At a time when retail investors show no sign of reversing their massive retreat from equity mutual funds, which accelerated after May 2010, the latest episode of an algo malfunctioning will do little to reverse the lack of trust in how the stock market currently operates.

The FT also quoted Themis Trading co-head Joe Saluzzi, who said:

When the price discovery process breaks down, investors can no longer trust the markets... The plumbing of the stock market has changed so much that it's hurting and destroying the price discovery process.

Mistakes: Where do we start?
Taking the easy mark first, I'll quickly point out that despite the continued drumbeat from the media that Average Joe and Jane Bagadonuts have lost confidence in the stock market and are no longer investing... they are. My fellow Fool Morgan Housel tackled this back in May using facts and numbers (imagine that!) to show that there's been no huge individual-investor exodus from the stock market.

As far as the psychological impact of the latest "attack of the trading machines," there are two parts to the question. First, will this hurt confidence? And second, should this hurt confidence?

On the question of will it hurt confidence: If we go back to the 2010 flash crash, average S&P 500 trading volume was 2.4% higher in the three months following the blip versus the three months prior to it. It certainly doesn't look like the big robot-induced dip convinced people to stop using the markets, so I don't see why its punier younger sibling should.

To be sure, the media will pull its hair out for a day or so over it, which slightly increases the likelihood of a reaction from investors. However, the ADD nature of the financial media means that a new news cycle will quickly blow in and this will be tossed in with Peregrine Financial as news that is soooo yesterday.

But should it bother us?
It's much more interesting to consider whether this should hurt investor confidence. If we revisit Joe Saluzzi's take from above, there are at least a couple of interesting things to note. First, Themis Trading's website makes it clear that they're deeply suspicious of the impact of electronic and high-frequency trading. This makes sense, as the rise of the machines has taken a toll on the ranks of traders. A big screw-up from a trading machine is a great opportunity for a guy like Saluzzi to jump in front of a mic and remind us why we need human traders. We can't blame him, but we can probably chalk this up partly to talking his book.

And though Saluzzi says "investors," he's not an investor; he's a trader. For a trader, wild unpredictability like this is bad news because wild, unpredictable moves lay waste to a trader's intuition about stock movements earned from decades of experience. This is particularly concerning when they have an institutional customer breathing down their neck to make a big transaction.

I don't mean to pick on Saluzzi or Themis in particular; this applies to trading/traders in general.

But for individual investors -- true investors -- this isn't nearly as concerning. Call me lazy for going back to Warren Buffett, but a couple of his quotes are all too fitting here:

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

If you're investing with this kind of perspective, some wonky trading because of a computer algorithm gone awry isn't something you lose sleep over.

More generally, though, investors shouldn't be counting on the market to tell them how much the stocks they own are worth. Investors should be doing the work on their own to figure out how much their stocks are worth. The stock market is simply a place to transact -- ideally, buying when a stock is underpriced and selling when it's overpriced.

So let the media have its Chicken Little episode with this mini-flash-crash. But sleep well knowing that, if anything, stupid robot tricks in the market will create opportunities for those able to keep their heads on straight.

On that note, are you looking for the types of stocks worthy of holding through a 10-year market shutdown? A good place to start is with the three Dow stocks that my fellow Fools highlighted in this special report: "The 3 Dow Stocks Dividend Investors Need." You can grab a free copy of that report by clicking here.

The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management and NYSE Euronext. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (22) | Recommend This Article (38)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 01, 2012, at 4:30 PM, TrojanFan wrote:

    Yeah, but we don't need more regulation guys.

    Market makers should be allowed to do whatever they darn well please and we should all just accept that we are hostage to their whims.

    If they want to pull back their bids in full collusion with one another to set off a panic so that they can consolidate their positions on the cheap and increase their wealth we should all just accept that that comes with the territory and is part of the game and if you don't like it then don't play.

    Or become a market maker yourself so that you can pursue your own rational self-intersest at the expense of everyone else.

    Cheers!

  • Report this Comment On August 01, 2012, at 5:22 PM, Observer310 wrote:

    Do whatever you want..Screw everybody..

    Me! Me! Me!

  • Report this Comment On August 01, 2012, at 5:30 PM, s73v3r wrote:

    I dont really think that trading volume is a very good indicator of investor confidence. It measures the number of shares traded, not necessarily the number of traders who bought/sold shares. There's a big difference there, and in the conclusions one can draw.

    And with regards to investor confidence, I'm sure there is a significant number of people who have very little confidence in the market, yet still think they have to have some position, because, and let's be honest, where else are you going to get returns of any real substance?

  • Report this Comment On August 01, 2012, at 5:35 PM, maliasmom wrote:

    The quotation from Mr. Saluzzi of Themis was not given to the Financial Times but to Bloomberg. Here is what I wrote today in my newsletter, global-investing.com at about 11 a.m.:

    Do Not Trade Today.

    After July produced decent returns for stock investors, the beginning of August brought another reason to worry about the integrity of US stock markets. There were swings of over 10-15 percent in a dozen US stocks, including Berkshire Hathaway, the vehicle of investment leader Warren Buffett, without any seeming reason. This led Bloomberg.com to conclude that a computer program was causing the price swings.

    New Jersey-based market maker Knight Capital Group which also operates in London and Hong Kong appears to be the designated source of the price moves, possibly because of broken algorithms, the wire service said. Commented Joseph Saluzzi, head of equity trading at Themis LLC, also in Jersey, to Bloomberg:

    "This is yet another example of how market structure plumbing is responsible for massive price distortions. August 1st will be another day that will destroy investor confidence just like the May 6th flash crash."

    After I published my warning against trading today, I returned to blog-writing. The London market remained unaffected by the US glitches, according to Charles, a financial reporter with whom I spoke.

    Among the stocks roiled today in unusual trading was Molycorp which bid for our Neo Materials (sold for cash in preference to MCP shares). Nearly 6 mn shares of MCP traded in less than 45 minutes after the opening, twice the normal daily volume, all over the price curve.

    The swings and roundabouts in Nokia pricing are what led me to learn about the Flash Crash II, but NOK was roiled by its own news. It lost a US lawsuit by InterDigital over some 3G cellphone patents which reversed the International Trade Commission ruling favoring NOK. So all that will go on for a while. However a rumor that after buying EMC Lenovo would be buying Nokia reversed the negativism. Lenovo denied it. The China-based desktop computer maker bought out IBM in this area a decade ago.

    Vivian Lewis

  • Report this Comment On August 01, 2012, at 5:43 PM, rpmarkman wrote:

    Matt, I can't agree with you. You don't need to subscribe to Warren Buffet's philosophy to be an investor. As someone who learned painful lessons from the telecom and dotcom bursting bubbles, as well as other market plunges, I (along with many other survivors) have learned to invest with trailing stops. This doesn't convert me from investor to trader. Market glitches and active manipulation of pricing are harmful actions to investors as well as traders.

  • Report this Comment On August 01, 2012, at 5:53 PM, gkirkmf wrote:

    As an average investor, the flash crash taught me a lesson about never selling or buying at the market. I always put a not to exceed price on any trade I do. No more trusting a market quote, even for a second.

  • Report this Comment On August 01, 2012, at 6:02 PM, dbtheonly wrote:

    And a flash crash plays havoc with the concept of trailing stops. How do you protect yourself when the "market" on a stock can drop to nothing for no apparent reason?

    Are we really rediced to indicies only?

  • Report this Comment On August 01, 2012, at 6:34 PM, yarbtly wrote:

    Have you thought of what these wild swings can do to stocks with trailing stops? Say you had a 15% trailing stop on Molycorp. Your stock would have been sold at the bottom before the price correction.

  • Report this Comment On August 01, 2012, at 6:36 PM, yarbtly wrote:

    Harmless my ass!

  • Report this Comment On August 01, 2012, at 6:53 PM, SJLATTY wrote:

    Limit orders, up or down, can be triggered by these events. I wonder how many trades occurred by such orders.

  • Report this Comment On August 01, 2012, at 6:56 PM, maiday2000 wrote:

    I agree with s73v3r, just because more shares traded hands says nothing about HOW MANY people are trading those shares, and it says nothing about WHO the people (or machines) are that are trading shares. It could be 10 people trading 100 million shares or 20 people trading 50 million shares.

    And Housel's stats have one glaring problem - they list the value of assets in stocks and mutual funds, but not as a total percentage of investable assets. Are the total assets in this country worth the same today as they were in 1999?? I don't think so. But, the value of stocks and mutual funds held by households is the same. Sounds to me like people are taking any marginal dollars and investing them somewhere else.

  • Report this Comment On August 01, 2012, at 6:59 PM, eldetorre wrote:

    Harmless? Absolutely not! "True investors" do not live in a world separate from speculators. The fact is that rampant speculation, and market manipulation, wreaks havoc with true investors looking for long term opportunities, because even though we are long term, companies are pressured to satisfy the goals of short-termers as well. Furthermore the markets themselves are skewed more and more to suit the needs of short term investors making millisecond profits.

  • Report this Comment On August 01, 2012, at 7:17 PM, dennyinusa wrote:

    Holding a stock for a millisecond is not investing. This should be taxed at high rate to stop this stupid practice. Why are these people allowed to skim off real investors profits. A company could not last if everybody held stock for milliseconds.

  • Report this Comment On August 01, 2012, at 7:39 PM, Canuck2010 wrote:

    Warren can follow his advice because he buys large position in companies if not the entire company and has a say in how the company is run. He can also afford to spend a lot of money doing due diligence before taking a position. For those of us of more modest means, I can't think of a single company I could commit to for 10 years, although I have owned some stocks that long. I have no intention of riding down some stock on a buy-and-hold premise just because I liked the company a year ago. Plus some people would like to generate some income or draw on their investments from time to time (e.g. a major purchase or life event).

  • Report this Comment On August 02, 2012, at 6:36 AM, SuntanIronMan wrote:

    @dennyinusa

    We already have that. The short-term capital gains rate. We already reward investors who hold for a longer period of time (or punish investors who hold for a shorter period of time, depending on your point of view). I doubt an even-shorter-term capital gains rate will make that much more of a difference.

  • Report this Comment On August 02, 2012, at 6:40 AM, daveandrae wrote:

    interesting...

    Equities are a lot like women in that one would think a hell of lot longer and harder about the one they were going to marry, if divorce were not an option. Not only would your error rate and annualized fees begin to shrink substantially, but just maybe, you might begin to ask the basic question "how much?" before you considered buying something.

    On the flip side of the coin, show me a person that buys with a "stop loss" and I'll show you a person that is locking in a permanent loss of capital.

    Individual stocks go down in price all of the time!

    The important thing to remember, especially in this business, is not what the market does on any given day, which, a year from now, not only won't be remembered, but will long since be forgotten.

    Rather. that which is most important, is to never forget what the market is ULTIMATELY going to do! Ultimately, the market is going to go higher than most people are capable of imagining. (My six figure equity portfolio has appreciated by more than 54% since the May 2010 "flash crash").

    This is especially important to remember if you are facing 30+ years of retirement.

    Over 30 years of retirement, consumer prices will easily double and in some cases, quadruple. That's 8+ dollar gasoline prices by the time my five year old son is 31. Thus, unless you have a sound plan to fight the relentless amount of inflation rolling down hill straight towards you, it is mathematical certainty that you will eventually run out of money.

  • Report this Comment On August 02, 2012, at 9:13 AM, SaraW946 wrote:

    I wouldn't blame Warren Buffett about the small investors taking a hit, because he is not an investment guru who writes books of the "how you can invest $1000 and become a gazillionaire" type. His "philosophy" and any related statements are meant for the big investors who handle gazillions, and it should be perceived as such.

  • Report this Comment On August 02, 2012, at 10:36 AM, wjcost wrote:

    I agree most heartily with those who say that "millisecond arbitrage" is not investing. It is pure and simple smart people (who should be physicists, engineers inventors) using computers to rip off the rest of us. This nonsense can best be stopped by imposing a small transaction tax to all stock trades, so small that it would barely tickle even the largest trades for true investment but imposing enough of a spread to make "millisecond arbitrage" less profitable. Such a tax could reduce the deficit and also reduce the tax rate on activities (business and individual income) that benefit humanity. I am sick and tired of the snakes and leeches who bleed us for the sake of profit with NO benefit to society at all. We need regulation to level the playing field and make it fair for all.

  • Report this Comment On August 02, 2012, at 5:21 PM, RetiredExCPA wrote:

    Once again, the little guy gets screwed by the big guy. I had a stop loss on DDD at 35. It declined "only" about 13%; therefore, since 30% is the criteria, my brokerage firm informs me that my forced sale sticks. I now have a short term taxable gain at a price lower than the stock value when Knight Capital caused the problem. My sale was at 9:31AM. Don't tell me it doesn't matter.

  • Report this Comment On August 03, 2012, at 2:52 AM, lowmaple wrote:

    Don't use stop losses!

  • Report this Comment On August 04, 2012, at 1:23 PM, tradingnaked wrote:

    Hey @wjcost, I wouldn't be doing millisecond arbitrage (in truth, I'm slower than that) if one of the many places I applied to would actually HIRE ME. But apparently I'm "not a good fit", or I intimidate the human resources bubblehead who's screening me, or...I don't know! In the few jobs I've been able to get (places that would hire anybody with a pulse), I was surrounded by women cooing, "ooh, you're too smart for your job!" (I'm female). So I left the job market once I built up enough capital to trade. I don't know about the other snakes and leeches, but I know I do this to pay the rent. I also shop for clothes and buy food - surely that's beneficial to the economy?

  • Report this Comment On August 16, 2012, at 8:21 PM, thidmark wrote:

    It's worth mentioning again ... don't use stop losses.

    When your stop loss kicks in is when you should be BUYING MORE.

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