I was at 30,000 feet when the crash hit on Thursday. When I landed in NY and saw what happened, the first thought was trader error. But the evidence for that remains lacking. I spent a good part of the weekend trying to track down evidence that it was HFT, or a fat thumb, or a NYSE erroneous trade halt.To date, the best analysis I’ve seen came from a young analyst on an institutional desk. His forensic approach to piecing together what occurred is the best explanation I have come upon:

~~~

While “trader error” or “a fat finger” may have been a catalyst for certain elements of the decline, it also may not have been. It may have been a “computer error” and it may not have been.

Do you notice how we’re unwittingly restricting our analysis to what the sellers did? The offer side of the trading that saw the S&P 500 lose -5% of its value in the span of about 3 minutes – that after it had already declined by over -3% – is a RED HERRING. It’s misdirection – hand wringing over what is irrelevant at the expense of ignoring what is relevant…and what’s relevant is the bid side of the market, that is, what the buyers did.

Volume was gigantic [Thursday] before we really went into freefall. As of 2 p.m., some 40 minutes before Armageddon, we were tracking for a massive 15.6 billion share day (we ended up doing 19.3 billion – the second largest day ever after the October 10th, 2008 whitewash). Half an hour later, at 2:30 p.m. – still ten minutes before the bottom fell out – volume had surged and we were tracking for a 17.2 billion share day. The period between 2 p.m. and 2:40 p.m. saw immense selling pressure in both the cash market and the futures market, and that occurred with the E-minis still north of 1120. Check out the below graphs.

>

June 2010 eMini S&P500, NYSE Volume

click for ginormous charts

chart via Bloomberg L.P.

>

In other words, it was not a sudden, random surge of volume from a fat finger that overwhelmed the market. It was a steady onslaught of selling that pressured the market lower in order to catch up with the carnage taking place in the credit markets and the currency markets.

Take a look at the next charts, the chart on the left, which clearly shows the surge in the yen preceding the drop in the stock market.
>

eMini vs Yen/Dollar

click for ginormous charts

chart via Bloomberg L.P.

>

But what about the final thrust lower – the seeming air pocket? We know, thanks to our friends at CNBC who were fixated on this particular stock, that Proctor & Gamble tumbled by over -35% in the span of about 5 minutes. It’s impossible to tell by looking at a chart of the stock, but when you look at the individual prints you can see that this was not a case in which two or three “erroneous” prints marked the tape down to $39 before the stock sprang back to $60. I’ve got 28 pages in front of me of P&G prints that occurred between $39 and $50 per share and between 2:46 p.m. and 2:51 p.m. At 36 prints per page, that means P&G traded over one thousand times at those “crazy” and “surely erroneous” levels. I’m sorry, but that isn’t an error, THAT IS WHAT WE LIKE TO CALL TRADING.

So what happened here? Three things:

1. Sellers probably had orders in algorithms – percentage-of-volume strategies most likely, maybe VWAP – and could not cancel, could not “get an out.” These sellers could be really “quanty” types, or high freqs, or they could be vanilla buy side accounts. It really doesn’t matter. The issue here is that the trader did not anticipate such a sharp price move and did not put a limit on the order. The fact that the technology may have failed does not mean the
trader deserves a do-over, it means that the trader and the broker who provided the algorithm need to decide whether any losses should be split.

2. Sell stop orders were triggered which forced market sell orders into an already well offered market.

3. While the market was well offered, it was not well bid. Liquidity disappeared. For example, in P&G, 200 shares traded at $44.10 at 2:51:04 in the afternoon and one second later, at 2:51:05, three hundred shares traded at $47.08. That’s a three dollar jump in one second. Bids disappeared, spreads blew out, and no one was trading except a handful of orphaned algo orders, stop sell orders, and maybe a few opportunists who had loaded up the order
book with low ball bids (“just in case”). High frequency accounts and electronic market makers were, by all accounts, nowhere to be found.

It boils down to this: this episode exposed structural flaws in how a trade is implemented (think orphaned algo orders) and it exposed the danger of leaving market making up to a network of entities with no mandate to ensure the smooth and orderly functioning of the market (think of the electronic market makers and high freqs who can pull bids instantaneously as opposed to a specialist on the floor who has a clearly defined mandate to provide liquidity).

Now that that is settled, we can return our attention to what caused the selling in the first place: Greek contagion. Currently, the euro is rallying on speculation that the European Central Bank is going to announce a reopening of its emergency 1-year funding program for its constituent banks over the weekend. Interbank lending has become more expensive as the perception of counterparty risk has grown more acute.

>

Euribor, Dollar Libor

click for ginormous charts

chart via Bloomberg L.P.

>

A thought here on the ECB’s action: It will likely prove as fruitless in stopping the carnage as the Fed’s liquidity measures taken in the summer of 2007:

• Greek contagion may represent a similar magnitude threat as the subprime debt crisis three years ago. Subprime debt service was contingent upon rising house prices and house prices were going inexorably lower – so the market was doomed, in effect. Peripheral European debt service is contingent upon rising tax revenues relative to government outlays in those countries. Is pulling off this austerity effort without instituting debt deflationary dynamics as doomed as subprime borrowers’ efforts to service their debts three years ago? For Greece and Portugal, it may be.

• If we say that Spain and Italy are not in the same pickle, and that these countries’ debt markets are analogous to the Alt-A mortgage market, maybe the contagion can be quarantined as it could not be in 2007. The X-factor is the growth trajectory of the euro zone and the extent to which that trajectory is depressed by a drop off in Greek and Portuguese demand and by general financial instability in the zone. If growth in Italy or Spain were to falter, they could become subject to the same treatment as Greece and Portugal are currently receiving (I should probably throw Ireland in there somewhere between Portugal and Spain). Like in 2007, it may take several more months before we understand how spikes in libor and euribor have affected European growth.

>

Category: Markets, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

45 Responses to “A Closer Look at the 1,000 Point Dow Plunge”

  1. wunsacon says:

    Q: How does a specialist safely make a market in a stock like LEH, a stock that was liquid but insolvent and could at any moment implode? Doesn’t specialist run the risk of being left with overpriced inventory?

  2. rktbrkr says:

    So the same high frequency mechanics that gently stroked the market higher on light volume for months contributed to a high volume selling climax on thursday. If this hypothesis is correct then there is really no justification for cancelling any trades – just as there has never been any justification for picking 60% off as a threshhold

  3. Sircornflakes says:

    The Euro has basically given back all of yesterday’s upside gains.

    Looks like the 1 trillion blip has come and gone.

    Let failed ventures fail be they firms and or sovereign states. Nothing in life is a better teacher than history.

    Yours the Euro!

  4. Robespierre says:

    BTW today:
    S&P futures vs fair value: -11.80. Nasdaq futures vs fair value: -19.00.

    Is 1 day the most a trillion buys these days?

    What you didn’t mention in you analysis is that for your theory to work most algo (volume wise) must be triggered by the same parameters (or similar) which I believe it is the case since developers rotate among companies and end up implementing the same algorithms. Also isn’t a drop of this type worthy of a Homeland security investigation?

  5. Simon says:

    Well I guess the central banks must be getting better at identifying the formation of these financial black holes because they were ready and waiting to announce that they were prepared to provide a “fix” if you will excuse the pun.

  6. cognos says:

    Hmm…

    I had heard that the largest quant funds have “language processing” type guys. This always seemed bland and meaningless to me. The basic idea was that they had algorithims that process “sentiment” and then of course they do this across all the news headlines on 1,000s of stocks. Even longer term on articles and blogs.

    But now that I traded Thurs… it all seems to come into focus. Those “language processing” algorithims picked up perfectly on the “sentiment” of traders watching CNBC. As the Greek riots were shown… every trader (myself included) started to lighten up, or really… accelerate our lightening up. These algos did exactly what they were designed to do… and were faster. They really picked up on a massive human sentiment.

    Of course, 5-10% later… both sentiments reversed. The algos dont actually want to be short, so they have to take profits. AND the opposite sentiment kicked in in my human behavior… as I saw AAPL at 205, I said… enough lightening, I’ll buy ALL(!) that.

    It was really well coordinated with the Greek rioting pictures on CNBC and Erin Burnett kinda did it in a sensationalized way… even though it was a tiny, ticky-tack protest. It wasnt like a 100,000 greeks marching. More like a small G-7 protest of malcontents.

  7. rktbrkr says:

    Cognos…Too bad CNBC didn’t have “Street fighting Man” playing in the background

  8. rktbrkr says:

    I don’t know if sub prime and Alt A are really analagous to PIIGS debt service problems but I do know that the RE bubbles in Spain and Ireland have had world class blowouts and Spain has 20% unemployment now and Ireland has 13% and Ireland has $200K debt per capita to service. Ireland’s debt is 3/4 the size of Spain’s with 1/10 the population. After iceland the Irish government guaranteed all bank deposits.

    Offhand I’d say Ireland will never be able to service it’s debt if the economy and real estate markets there don’t rebound quickly and massively and Spain’s ability to implement austerity will be severely limited by their 20% unemployment. I’m sure the Euro zone will put a lot of lipstick on these PIIGS but they will need to restructure their debts

  9. flipspiceland says:

    Why should something you can create with a three zeros on a keyboard have any lasting effect?

    One day is actually too long, as the drop in the Euro after a $.03 spike, proved. Didn’t even last 18 hours.

    Who here wouldn’t love another “No-Bid” few minutes, if not a few hours.

  10. Greg0658 says:

    I wonder if Prof Hawking reads TBP (under what sudo would he post)?
    I wonder if outer space aliens crash landed a ship for us to reverse engineer its technology .. I wonder if they out there have a VIXmarket instrument for our final day .. I wonder if they have the same problem as us (a secret beam that will let a major player win without the others knowledge) .. 2012Dec21? (-:

  11. peterpeter says:

    > the danger of leaving market making up to a network of entities with no mandate to ensure the smooth
    > and orderly functioning of the market (think of the electronic market makers and high freqs who can
    > pull bids instantaneously as opposed to a specialist on the floor who has a clearly defined mandate to
    > provide liquidity).

    Mandate or not, humans would have made absolutely no difference.

    In the face of market sell orders (which I still contend were mostly from retail stop loss and market orders, as well as ludite funds using ancient algorithms), no human market maker would step up to the plate more than a few times and bid on shares, just to see the bid constantly being taken out by another market order.

    For evidence, we need only look at the 87 crash.

    You can not mandate that markets will move orderly. You can stop trading at whatever intervals you like, but you can never mandate people to step in front of a freight train and take massive losses… and even with said mandate, you can’t possibly expect it to amount to much good.

    Barry – you say HFT is like an umbrella for when it is sunny out, ignoring that trading costs incuding spreads and commissions are lower now than they have ever been in the history of trading. Perhaps you would like to go back to trading in 1/8ths of dollars and get shafted by human market makers (how quickly we all forget Nasdaq’s market maker collusion of prior decades), but I suspect you would quickly revise your opinion.

  12. farmera1 says:

    All of this “uncontrolled vibrations/cycling” makes me very nervous as a small investor.

    I can’t help but think of the Tacoma Narrows Suspension Bridge that started vibrating and oscillating wildly in the wind and finally collapsed in a heap of rubble in 1940. Some how there seems to be that sort of thing going on in to-days markets. Once the natural frequency is reached, look out.

    Loss Vegas seems to be a better bet than to-days markets. With the wild swings in to-days markets there is no investing, just gambling and you don’t know the rules, who is making the rules or the odds. Also I have the feeling either no one is in control (except maybe the computers) , or the nefarious people in control are doing their best to separate you from your money.

    Stephen Colbert’s comment works very well here.

    “he was a strong supporter of capitalism, unless he thought he could make money from its demise”

  13. Pat Shuff says:

    Not a bug but a feature, a full length creature feature.

  14. mrconsulting says:

    What about this as a contributor to the drop?
    http://online.wsj.com/article/SB10001424052748704879704575236771699461084.html

    I’m always curious as to how dynamic hedging by big banks contributes to mkt spikes & drops.
    I think the total $ amount of this initial trade isn’t that large, but the potential dynamic hedging used to offset this trade could have a significant impact on the market if the conditions were right.

    It reminds me of how dynamic hedging probably contributed to 2008 drops where banks had to offset risk exposure to other banks, and thus the biggest short sellers of banks may have been banks themselves.

  15. rktbrkr says:

    Meanwhile on the Eastern front

    Guess whats going to happen, I think we’ve seen this show before

    May 11 (Bloomberg) — China’s inflation accelerated, bank lending exceeded estimates and property prices jumped by a record, increasing pressure on the government to raise interest rates and let the currency appreciate.

    Consumer prices rose 2.8 percent in April from a year earlier, the fastest pace in 18 months, and property prices jumped 12.8 percent, the statistics bureau said in statements today. New lending of 774 billion yuan ($113 billion), announced by the central bank, was more than any of 24 economists forecast.

  16. When Mr Market starts swallowing your ‘fixes’ in one bite like the cat swallowing the canary then trouble is brewing. I remember this type of behavior before the debacle at the turn of the century. Mr. Market makes a fool out of its ‘administators’ and then he gets nasty.

    The gold bull was having a bit of fun too. Running off and shouting ‘cluck, cluck!’. It too has turned and lowered its horns. This is at a time when the gold bull should be on spring break. This is definitely out of character for it.

    I don’t like the look in the gold bull’s eyes

    Be cautious. The game is afoot

  17. [...] speaking of last week’s plunge, Barry Ritholtz offers up “the best analysis I’ve seen from a young analyst on an institutional desk”: It boils down to this: this episode exposed structural flaws in how a trade is implemented (think [...]

  18. pintelho says:

    I will say this about last Wednesday…I am a TD Ameritrade user and I use the Think Or Swim platform to enter orders…That morning I was on a mission to exit my longs due to lots of my indicators signaling exit.

    In placing the orders there were lots of problems in confirming them…and then Cancelling them in order to put new ones in (I use limit orders…so if the bid runs away from me…I have to cancel and enter a new one).

    The helpdesk people at TOS and TD were saying that this was a problem with the exchanges not signaling back to the brokerage that the orders were cancelled or entered…

    This was happening right at the open and all morning during trading….I think it is fair to say that the computers were already screwing up things early in the day and perhaps they got ultra bogged down as the day progressed….engineering the crash.

    So you have the HFT machines doing their thing on a day when the exchange computers were already backed up in the morning….

    Recipe for disaster and the halting mechanisms simply didn’t fire.

  19. Isis says:

    The “what happened on Thursday” discussion is full of misinformed pontification. There is no point in speculating what happened. Each ECN and exchange knows every order submitted to the exchange for a given instrument and every order canceled as well. Let’s put some pressure on them to disclose details instead of engaging in this pointless banter.

  20. Robespierre says:

    @rktbrkr Says:
    May 11th, 2010 at 9:05 am

    “I don’t know if sub prime and Alt A are really analagous to PIIGS debt service problems but I do know that the RE bubbles in Spain and Ireland have had world class blowouts and Spain has 20% unemployment now and Ireland has 13% and Ireland has $200K debt per capita to service. ”

    No they don’t. Buying RE in Spain involves a down payment and the interest is always variable. There is a very strong desire of the population to own RE to protect against inflation (carry over from the days of the peseta). The %20 unemployment is very misleading. There is a lot of that %20 who work “off the books”. Neither businesses nor the individuals want to pay taxes so they work for cash and get “paro”. Also culturally Spaniards are not debt happy like Americans. Also a huge component of the RE bubble in Spain was from Brits, Germans and Arabs buying condos/houses as investment and vacation.

    Having said all that I’m sure that there were ways to bypass the down-payment on RE some how.

  21. contrabandista13 says:

    Barry:

    You’re missing the whole point here…. It was a cyber attack plain and clear….. No conspiracy theory here….. The only rule that may have been technically violated is the traders daily limit rule. It was Chinese players, they have been probing and monitoring the market for the last two weeks. Their play was in the minis, P&G was an electronic catalyst to get the ball rolling…. The entire thing was an electronic play. It was the same group that ran the gold minis 70 bucks plus pre-opening, back in the summer of 2005….. However, that event went unnoticed…

    Things like this leave everybody scratching their heads…. and none of the big shot traders are willing to admit that they got caught off guard…. Even the HFT algos got reversed and whipsawed as they ran into asymmetric scale down buying pyramids near the bottom of the range…… Duh….!

    “You tie my tie, I tie your shoe…..” (say it fast and loud) That’s Chinese for…. “so-long sucker…..”

    Best regards,

    Econolicious

  22. farmera1 says:

    In the mean time Goldman has a perfect trading quarter. No losses at the end of the day. The odds of this really happening in a level playing field; higher than I can even fathom.

    “Traders raked in more than $100 million daily for 35 days and made no less than $25 million daily during the rest of the three-month period, according to a regulatory filing.”

    http://finance.yahoo.com/banking-budgeting/article/109514/goldman-traders-had-a-perfect-quarter?sec=topStories&pos=2&asset=&ccode=

    That is way cool. Trade billions and billions and not loose on any trading day. Even Barry isn’t that good.

    Come on Barry, you will have to raise the bar a little higher.

  23. tradertim says:

    Anyone notice CNBC hasn’t shown any shots from Greece since Thursday?

  24. retrogrouch says:

    On the conspiratorial end consider this:
    http://www.npr.org/templates/story/story.php?storyId=126097038

    Richard Clarke on the growing cyber war threat.

  25. Peter Pan says:

    It doesn’t matter if it’s the specialist on the floor, electronic market maker or HFT. They will pull out when the selling gets overwhelming. The selling was overwhelming on Thursday.

    It appears to me that $USD carry trades had been switching over to $JPY carry trades but got run over anyway by a strengthening $JPY.

    It’s not an enemy attack or a conspiracy. It’s a mix of structural weakness and stupidity all around. The frequency of occurrence will be increasing in the future so get used to it.

  26. Joey says:

    Thanks Barry…good stuff.

    IMO, the take away is that the market was already tanking before the accelerated decline started. That lends further credence to it possibly being a structural flaw and thus not as nefarious as some may believe.
    Regardless, the algos and HFT need to be reigned in (as if it will ever happen).

    btw, I had two of my trades near the Thurs lows canceled, which is fine. But one of my buddies had a 1.3M profit erased to +10K. That sucks.

  27. Daffyorbugs says:

    Why do people have so much trouble with loose and lose? Is it a typing error? I’ve seen this mistake probably a thousand times.

  28. NotQuiteSo says:

    Didn’t we see this yesterday on NakedCapitalism? Just asking.

  29. purple says:

    German banks hold a lot of the plummeting real estate in Spain. That’s the nexus of the next crisis in Europe.

    Italy is more like Japan, most public debt is domestic.

  30. That is way cool. Trade billions and billions and not loose on any trading day. Even Barry isn’t that good.

    No, but Bernie Madoff is!!

  31. farmera1 says:

    So what business is Wall street in? Here’s a perspective that sounds reasonable.

    http://blogmaverick.com/2010/05/09/what-business-is-wall-street-in/

  32. yosull says:

    Barry,

    What is your personal take on HFT? (sorry if I have missed your post if you have penned one)

    It scares the $%@# out of me. To me, it is a tax on trading/investing, and resembles the usefullness of a blood sucking leach!

    That said, what would happen if they banned it?

  33. [...] between 2:46 pm and 2:51 pm,” Thursday afternoon, an unnamed analyst at an institutional desk writes at The Big Picture. “At 36 prints per page, that means P&G traded over one thousand times [...]

  34. Ted Kavadas says:

    This is a very interesting post with good info. It is certainly far different than what has been widely reported.

    I think that the events of May 6 were truly a “Black Swan” event. To my knowledge there has never been a time when a group of liquid stocks went down to a penny momentarily – not to mention all of the other strange activity.

    I think the day’s events are highly significant, as is the fact that so far no “obvious” reason has been determined for such freakish events.

    I’ve raised a number of issues about May 6 that I believe deserve recognition…here is the post for those interested:

    http://www.economicgreenfield.com/2010/05/10/thoughts-on-the-may-6-stock-market-plunge/

  35. cdosquared5 says:

    Not to be obnoxious, but wouldn’t a contrarian take from the criticism of HFT be that how quickly the market rallied from the intraday lows show that the current market microstructure is much better at supplying liquidity during a panic / crash, as compared to the 1987 crash?

  36. WolfStreet says:

    OR : “the harder they come the harder they’ll fall”.

    sounds better with some music though…

  37. BR,

    Great summary. My question is that can an old style specialist system work in today’s electronic markets? Nasdaq has survived without a true specialist system, but the old system where the specialist had a mandate to buy seems like it is needed these days.

    Without some type of assurances in the market place that a person can’t go to the bathroom while the markets are open for fear of a market meltdown, how are they going to bring confidence back to the system? Is this the new paradigm for the markets?

    I haven’t seen too many people freaking out about having a lack of confidence in our markets but I was shaken to the core seeing the volatility. And we thought real estate was a sure losing proposition.

  38. rktbrkr says:

    Robespierre, From John Mauldin August 2009
    Spain is set for a long, painful deflation that will manifest itself via a very high unemployment level for an industrialized economy, a real estate collapse and general banking insolvencies.

    Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the US, even though the US is about six times bigger. Spain is roughly 10% of the EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU. Most of the new homes were financed with capital from abroad, so Spain’s housing crisis is closely tied in with a financing crisis.

    The impact on the banking sector will be severe. Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That’s almost 50% of Spanish GDP. Most of these loans will go bad.

    Spanish banks, in our view, are now facing a very bleak outlook. Spain’s unemployment rate reached over 17%; there are now four million unemployed Spaniards and over one million families with not a single person employed in the family.

  39. Pir2 says:

    i have to disagree, contagion from Greece was already in the basket. Europe will have never left Greece default. This not what was new this week. i say this is link to the Time Square failure. This is funny that aphatradingsystem which want to be the next TSX was down for the week due to some trouble. any other systems down for that specific week?

    i know this is so into the conspiracy theory but if you think you can replicate this dive then why would you not think that somebody already though about making $ about it. one will be to check who made $ during that time, short and long and see if they were legitimate.

  40. Nic says:

    http://dealbook.blogs.nytimes.com/2010/05/12/market-inquiry-focuses-on-one-trader/?src=twt&twt=nytimesdealbook

    They are seriously focusing on one trader because he “only sold and didn’t buy”. What a joke. This market is still humans and when you switch the machines off herd behaviour happens.
    In October 1929 on the Thursday before Black Monday the market fell hard and bounced and everyone blamed “excessive leverage”. There is always something to blame but it still happened.

  41. mosheobrien says:

    After this panic selling on Thursday, the market will continue to go higher. Time to buy more!

  42. [...] sudden drop on May 6th is finally beginning.  Amidst the confusion, I came across the following description on Barry Ritholtz’s blog: [I]t was not a sudden, random surge of volume from a fat finger [...]

  43. [...] now works; Chris Whalen at Institutional Risk Analysis comes to mind, a trader Barry Ritholtz cited at The Big Picture (”that is what we like to call trading.”) Another is the anonymous [...]

  44. [...] phenomenon may have played at least a partial role in the flash crash of May 6, 2010. (Here’s A Closer Look at the 1000 Point Dow Plunge if you’re interested in the nitty [...]