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May 19, 2010

Why the Core of the Problem Is An Old-Fashioned Order Type

It had to have been a fat finger. Like many trading professionals, I assumed that the historic 1,000-point bungee jump in the market on May 6 had a simple explanation--a "fat finger," Wall Street parlance for a mistake. Most traders went to bed that Thursday night looking forward to reading about the unfortunate schlemiel who hit the button. I imagined a 22-year-old assistant who keyed in "billion" instead of "million," who then absent-mindedly clicked through five increasingly dire warning screens while in a rush to make the afternoon Starbucks run. I thought we'd all know his or her name within 24 hours, and the story would become a great source of jokes for years to come. If we were really lucky, Mr. Fatfinger would turn out to actually have big fat fingers, after which giant keyboards would be mandated for traders, and we'd all move on. 

But sadly, we were denied getting a simple explanation, and we were denied getting cool new enlarged keyboards, because almost two weeks in, no clear culprit had been named. I had to finally acknowledge that the blimp-fingered blunderer I had dreamed up did not exist, and the answer was far more complicated than a simple error.

To review what happened on May 6: Starting around 2:40 p.m., stocks began sliding rapidly, accelerating a few minutes later into a total freefall. A handful of stocks were momentarily wiped out, trading all the way down to a penny. Then the momentary lapse of reason ended as quickly as it started, and the affected stocks soon rebounded. Four hours later, the exchanges announced they were arbitrarily busting the trades they deemed most egregious, while allowing the merely preposterous ones to stand.

The lack of a simple answer had all of Wall Street pondering--if it wasn't an error, what was it? Theories were flying as to what triggered the initial wave of selling. The conspiracy theory held that an evil genius options trader who was long volatility purposely caused this "Black Swan" event, with the Wall Street Journal even dangling the enticing possibility that the author of The Black Swan himself was involved. Then I heard an even more fun theory when a radio show caller proposed it was financial terrorism from abroad. Yes, rather than a trader with a fat finger, it was Bin Laden giving us the finger.

By a week into the investigation, the convergence theory seemed to be winning. The theory held that unusual conditions combined to form a financial perfect storm capable of generating gale-force market winds. In short, the explanation went something like this: The Greek riots created nervousness, volatility spiked causing quants to reduce their maximum position sizes, and then an initial selling wave from a large money manager hit the S&P futures knocking it to a discount.  As stocks followed futures down, the NYSE began to hit its "Liquidity Replenishment Points," removing its bids from the public quote, and simultaneously retail stop-loss orders began getting triggered, generating a fresh deluge of market orders. Electronic market makers began getting long tons of stock, and with futures at a discount, they couldn't hedge effectively, and therefore stopped buying. Bids then rapidly faded, and with no one left buying, the market collapsed.

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