Thursday, May 6, 2010

High Frequency Trading Run Amok

So the big news of the day was the huge sell off in US markets.  The final tally was -340 points on the DOW (-3.20%), -37.72 on the S&P500 (-3.24%) and -82.65 on the NASDAQ (-3.44%).  This is a bad day but the intraday lows is what has everyone really talking.  In the span of only a few minutes the market veered completely off the rails, with the DOW dropping nearly 1000 points on the day before recovering most of the losses nearly as fast.

The initial explanation for the plunge was the rumor that a Citi trader fat fingered an order of Proctor and Gamble (PG).  We did not buy this explanation for two reasons.  First, the market was already sliding well in advance of the alleged PG trade.  Second, the volume in Proctor and Gamble stock during the alleged mistaken order was not nearly as great as one would expect given the explanation.  After the market close came official word from Citi that they have no evidence that an erroneous trade was made on their partOur initial take was that the obvious culprit was program trading gone awry, and lo and behold that is now what the NYSE is reporting.

The chart pattern marked out today by all of the indexes is very familiar to anyone who has been watching stocks like Citigroup, Bank of America, AIG and several others intraday over the course of the last few years.  The five stages of such market activity are as follows:
  1. Gradually sliding prices throughout the day
  2. This is followed by a massive waterfall
  3. A V-bottom is created
  4. A large spike right back up is generated
  5. The day ends with a continued rise into the close
Here is a view of today's DOW with these five stages labeled:

This type of market activity is the sure sign of high frequency computer trading run amok and is not something that you will see when human traders participate in an orderly market.

In our minds today's market activity begs two questions.
  1. What kind of dopey artificial markets have we created and why would any sane individual want any part of them?
  2. To this you trust your retirement funds?
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