I have been trying to piece together what the heck happened yesterday afternoon when the Dow at one point plunged 1000 points. The selloff was short lived and low volume and the increasing prevalence of computer based trading appears to be the cause.
For whatever reason, the NYSE slowed down trading in Procter & Gamble (PG) stock, and possibly a couple of others. In that case, there is no bid on the floor of the NYSE, drying up some liquidity. Because around 2/3 of the trading volume in NYSE stocks is now computerized, those computers go looking for bids off the NYSE floor. With less liquidity, there can be bigger gaps between bid and offer, resulting in bigger price swings.
Further compounding the problem, a number of high frequency trading firms stopped trading in the market selloff, further drying up liquidity, according to The Wall Street Journal. For example, Tradebot Systems of Kansas City, MO, which often accounts for about 5% of the volume in NYSE traded stocks, stopped trading after the Dow had plunged 500 points. “That’s what we do for safety. If the market’s weird, we don’t want to compound the problem,” said Tradebot Founder and Chairman Dave Cummings (“Did Shutdowns Make Plunge Worse?”, Scott Patterson, The Wall Street Journal, May 7, C1).
In this case, we have a situation where the number of bids is much smaller than it ordinarily would be i.e. there is low liquidity. In that case, a market sell order is at risk of being excecuted at an extremely low bid as the computerized trading platforms go looking for the best bid in an environment in which there are very few bids. Ridiculously low bids can get hit in this kind of situation, which appears to have happened yesterday afternoon in Procter & Gamble and Accenture which traded some shares as low as $39 and 1 cent compared to prices of $60 and $41 in the minutes leading up to the collapse.
Procter & Gamble is a Dow component. When it traded at $39, this knocked a huge amount of points off the Dow. I would like to see somebody calculate the exact effect of a drop from $60 to $39 in PG on the Dow. If other Dow stocks had similar situations, the effect on the Dow would have been compounded.
The drop in certain stocks and major indexes then causes other computerized sell programs to kick in, resulting in further declines.
Investors across the world also see the Dow plunging and panic.
What starts as a computer glitch becomes a mob panic.
Here are some good articles I’ve read on the subject:
“Surge Of Computer Selling After Apparent Glitch Sends Stocks Plunging”, The New York Times, May 7, B7
“Did Shutdowns Make Plunge Worse?”, Scott Patterson, The Wall Street Journal, May 7, C1
“Trading System May Have Dangerous Flaw”, Bob Pisani, TraderTalk, May 7, 9:22am EST
“Why The Trades Were Clearly Erroneous”, Bob Pisani, TraderTalk, May 6, 9:58pm EST