Knight Falls: Mr. Market Shows Off a Mean Right Hook

I confess: I was a little surprised by the reaction to my article about the Knight Capital (NYSE: KCG  ) trading glitch yesterday.

Reader TrojanFan was the first to weigh in, quipping: "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."

Obvserver310 was quick to follow with the more concise, "Do whatever you want..Screw everybody.."

A high percentage of the remaining comments centered on the problems with trailing-stop orders caused by Knight's trading bonanza.

I can't say that I'm the same page with these frustrations.

Mr. Market is swift in his judgment
First, readers like TrojanFan and Observer310 seemed to think that my view that the trading glitch shouldn't shake investors' confidence was an implicit endorsement that firms that use automated trading should be able to do whatever they want, no matter what that means to the proper functioning of markets. Nothing could be further from the truth.

In general, I'm a fan of more aggressive regulation in the financial industry, but in this situation we're not talking about a moral hazard issue where Knight was trying to do something -- a la MF Global's (OTC: MFGLQ) bet on euro-area debt -- that could have had a big payoff for those at the top or a company-imperiling downside. The Knight case was a mistake, plain and simple. If the glitch hadn't been there, it wouldn't have been some big bonanza day for Knight; it would've been business as usual.

Furthermore, the crime here is self-regulating, as the company managed to lose $440 million in the 45 minutes that the algorithm was trading like crazy. The market is meting out drastic punishment as well, knocking around three-quarters off the value of Knight's shares. Customers that route orders through Knight -- from Citigroup (NYSE: C  ) to TD AMERITRADE (NYSE: AMTD  ) -- were tepid about resuming trading with Knight. The company is now struggling for survival and has hired Goldman (NYSE: GS  ) and Sandler O'Neill to try to quickly raise money or sell itself.

Saying "let the market handle it" has such a political bent these days that I'm hesitant to say that, but in this case, I think it's apt.

Buy low, sell... lower?
As for trailing stops, I'm still a little lost about the attraction of these orders. For those who aren't familiar with them, trailing stops say "if the stock price falls below this value, sell." It's one of those quirks that, to me, perfectly illustrate the odd way that people approach investing versus everything else in life.

Let's say, for example, that I have a stack of CDs that I believe is worth around $50. Let's say I take that stack to a flea market and leave it with a friend while I go wander around. What I wouldn't say is: "Don't sell these CDs unless you hear that somebody else at the flea market has sold a similar set for $30."

Similarly, I'm no eBay expert, but I know that they have the option to set a reserve price -- which would allow me to specify that I won't sell my CDs for less than, say, $45 -- but as far as I know, there's no option to automatically sell if somebody else has transacted at a price that I would consider unattractively low. And I can't imagine that eBay users are clamoring for the company to add that functionality.

If I'm audacious enough to think that I can find opportunities where the market has mispriced a stock so that it's worth more than what it's selling for, why would I want to automatically sell that stock just because the market has further mispriced it? The logic has never made sense to me.

There's a lot more of the Knight Capital story to be told -- from how this glitch managed to slip through the cracks to the regulatory fallout -- but one thing is absolutely sure at this point: Mr. Market has given Knight Capital a swift, devastating kick to the teeth for its misstep. And I say good for you, Mr. Market.