photo by pedrosimoes7

Written by Nathan White, CFA

Last Thursday’s remarkable “insta-crash” has resulted in a frenzy of activity to determine the “cause”.

Rumors spread wild about all sorts of causes, but as the facts come to light, it looks like there was no single cause, but rather the culmination of many events, which led to a quick sell-off.

The initial and widely reported “fat-finger” mistake at a trading house seems to be a hasty conclusion and is fading fast.

A Wall Street Journal article by Scott Patterson and Tom Lauricella on Monday reported that a possible trigger that caused the Dow to lose 700 points in about five minutes might have been triggered by a hedge fund placing a large option bet.

This caused people on the opposite side to hedge by selling, which caused others to sell, which caused more selling and triggered sell-stop loss orders, which resulted volatility caused the high frequency trading firms (they account for upwards of two-thirds of stock market volume) to stop trading thereby removing a significant amount of liquidity, which resulted in a few minutes of very thin to no bids for stocks (I witnessed this as some stocks were down almost instantaneously 50%!).

All of this occurred within the backdrop of continuing video feeds of rioting in Greece, which had already contributed to a 3% drop in equities for the day before the “insta-crash”.

Then, as soon as it started, it was over…

About 10 minutes after the markets hit a low, they were back to pre-crash levels. Many have said that the markets failed to work, but I actually thing the opposite is true.

Because the markets were able to snap back so quickly, it shows that the sell-off was not justified. As soon as the market participants were able to start reacting to the dramatically low prices, bids reappeared and liquidity entered causing the market to snap back. It happened so fast that there was virtually no time to try and take advantage of the opportunity.

During these type of events quote and trading systems often freeze up and get bogged down as the systems become temporarily overwhelmed. Placing markets orders can be perilous because you do not know what price you will get and your limit orders are being constantly left behind.

The lesson from that day is that “events” like these will always be a possibility and will occur. The one thing that you should NOT do during these events is sell, because it is effectively too late.

Emotions run extremely high, and reason flies out the window. It is very hard to make sound decisions when in panic mode.

If you are positioned how you want to be before the event, it is absolute futility to try and sell during a “crash”. I firmly believe that you should wait it out and make your allocation decisions when the market has “normalized”.

As I mentioned initially, everyone is falling all over themselves to determine the cause of the crash so that they can stop it from happening again.

They can’t.

Congress, ever wanting to be seen as the saviors, is holding congressional hearings. Heaven help us.

Their “solutions” will likely cause more harm than good. The exchanges are also frantically trying to figure out some preventions. My main reservations with these groups’ potential fixes is that whatever they come up with to supposedly stop the market from going down also will likely hinder it from recovering.

Congress of course is mainly about intentions and not consequences whereas in “real life”, it is all about trade-offs. They like to make rules that on the face of it seem simple such as, “if the market is going down due to selling why don’t we just prevent selling by halting the market and presto, the selling stops” without considering what the consequence of their actions.

Trading halts, which I am not totally against, are no panacea and often make matters worse as it gives time for more people to panic and spread rumors and so when the market opens it gaps down ever further than what would have occurred without the halt.

The action on May 6th happened so fast that there really wasn’t time for the vast majority of investors to react.

My experience tells me that many would have reacted badly (panic selling) if they were given more time by something like a trading halt that would have dramatized to the nth degree by the media. The quick recovery prevented many from hurting themselves and is a main reason why I believe that the market did not “fail” us.

Click on this link to read the Wall Street article mentioned above, Wall Street Journal.

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