Commentary: Market Madness
Traders Magazine Online News, May 19, 2010
Regardless of the explanation, the results of the day revealed a serious flaw in our market structure. We all saw the reality--that there are no mechanisms in the current market system to stop panicked sellers, or fat fingers, or just plain old stupid orders from whacking a stock all the way down to zero. While politicians reflexively blamed high-frequency trading, and some blamed any traders who pulled their bids in the midst of the maelstrom, no one pointed out the obvious: that a stock can only go as low as the lowest-priced sell order. The people at fault for driving stocks to a penny were not the traders who made a rational decision to avoid buying in a moment of great uncertainty. The true culprits were the sellers who were willing to pound these stocks down to any price by using a dangerous tool called a market order.
An order to sell "at the market" is a limit order with a price of zero, while a buy market order is even more frightening, being a buy order with a limit of infinity. The order type is based on faith that the other side will materialize at a reasonable price, which is unlike how people buy or sell almost everything else--no one bids for a house, or even for a pair of Yankees tickets without putting out some maximum price. Yet the majority of orders in the equities market from mom-and-pop investors are sent at the market. On normal days, this isn't a problem, since professionals are around to absorb this steady barrage. But if the pros momentarily step out, as happened on May 6, the constant flow of retail market orders guarantees that stocks will lurch to ludicrous levels.
There are a few ways to attack this problem. The exchanges and regulators are currently focused on installing "circuit breakers," automatic trading pauses that trigger in the event an air pocket is hit. The latest plan calls for trading halts triggered by any trade outside of a designated price range, followed by an opening auction a few minutes later. As long as the pauses are long enough to give people time to examine their orders and make trading decisions, the circuit breakers should be effective. But one problem with halts based on prints is that they don't trigger until after there's already been a bad print--the equivalent of having the troops put on Kevlar vests only after the first soldier has been shot.
More elegant would be a futures-style limit down, which simply doesn't allow trades below a certain level, until some amount of time has passed, and then the level is reset. With limit down, the bad trade would be stopped before it happens, making "clearly erroneous" trade breaks announced at 7 p.m. a thing of the past. A limit-down system is the most conservative, the equivalent of wearing bullet-proof vests before anyone's been hit.
But while circuit-breakers or limit-down mechanisms can certainly minimize the damage caused by erroneous bullets, if the bad order is still not cancelled, the stock may just plummet again after the re-open. Wouldn't it make sense to try to stop the bullets from being fired in the first place? The best way to do that is to remove the gun: Eliminate the market order. Make retail investors think about the lowest price where they would really be willing to sell, including mandating price limits on stop-loss orders.
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