Many investors rely on the idea that the financial markets are efficient, with prices that accurately reflect all the information available to them. It's hard to imagine, though, how anyone could still truly believe that after the way the stock market acted yesterday.
Fast and furious
For a few minutes between about 2:45 and 3:00 p.m. yesterday, it looked like 2008's market meltdown was replaying itself. In about 20 minutes, the Dow went from being down 250 points to a 1,000-point drop. Within the next 10 minutes, though, the average had recovered all but 150 points of its plunge.
Prices on individual stocks saw similar whipsaws. According to Yahoo! Finance, Procter & Gamble
In some cases, the losses were even more surreal. Yahoo! Finance data showed one broad-based exchange-traded fund, iShares Russell 1000 Value Index
As of this morning, rumors are still flying, but it's not clear yet exactly what happened. Various news sources have reported that the culprit may have been an erroneously entered trade on a stock index futures contract. The rumored typo on a sell order on equity index futures, replacing $16 million with $16 billion, would have been a large enough transaction -- especially when coupled with automatic trading program responses -- to wreak the sort of havoc that the markets saw yesterday afternoon.
Don't get burned
When markets are functioning normally, it's relatively simple to buy and sell whatever stocks you want. Although some stocks are small and illiquid enough to merit extra care, you can generally count on big blue-chip stocks to trade normally, with relatively narrow bid-ask spreads and accurate pricing.
But this isn't the first time the market has seen quick plunges like this. Throughout the past 25 years, violent swings have plagued the markets from time to time. The problem even prompted the exchanges to set up circuit-breaker rules that call for temporary trading closures when stocks drop below certain levels in a single day.
There are a couple of big ways in which a snapback like this hurts investors:
- If you panic and use a market order to sell your shares at any price, you have no assurance that you'll receive any particular minimum amount for your stock.
- Some traders use stop-loss orders to try to lock in profits. If the stock falls below the level that you set in your stop-loss order, then your broker will automatically enter a sell order for your shares. Unfortunately, during quick plunges, these stop-loss orders tend to cascade on each other, causing an avalanche of selling pressure that makes a drop worse than it would otherwise be.
It appears that both the New York Stock Exchange, run by NYSE Euronext
Luckily, it's easy to avoid these problems. All you need to do is to use limit orders. That way, you set a minimum price you're willing to accept when you sell. The risk is that you won't always get a buyer for that price -- but you won't have to worry about taking a big hit when the market malfunctions. Your broker may let you enter limits on stop-loss orders as well.
Better yet, a limit order can help you take advantage of situations like this. If you enter an order well below the market, you may get a chance on days like this to buy shares on the cheap -- and you don't even have to be at your computer. Most of the time, those orders will never execute -- but when they do, they can be extremely lucrative.
Unfortunately, thinking that the financial markets are perfectly efficient is naive, and it can be dangerous as well. By being careful about how you go about buying and selling shares, you can avoid making unnecessary and potentially costly mistakes.
Was your broker up to the task of dealing with yesterday's market turmoil? If not, check out our Discount Broker Center for ideas on where to switch.
Fool contributor Dan Caplinger took the opportunity yesterday to reminisce about his experience of the 1987 stock market crash. He doesn't own shares of the companies mentioned in this article. Accenture, 3M, and Nasdaq OMX Group are Motley Fool Inside Value recommendations. NYSE Euronext is a Rule Breakers selection. Motley Fool Options has recommended writing covered calls on Nasdaq OMX Group. The Fool owns shares of Procter & Gamble, which is also an Income Investor choice. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will never crash on you.