Boy, this programmed trading is GREAT! I do love new toys.
By Daniel Wagner and Marcy Gordon
Associated Press
3:02 p.m., Friday, October 1, 2010
WASHINGTON (AP) — A trading firm's use of a computer sell order triggered the May 6 market plunge, which sent the Dow Jones industrial average plunging nearly 1,000 points in less than a half-hour, federal regulators said Friday.
A report by the Securities and Exchange Commission and the Commodity Futures Trading Commission determined that the so-called "flash crash" occurred when the trading firm executed a computerized selling program in an already stressed market.
The firm's trade, worth $4.1 billion, led to a chain of events the ended with market players swiftly pulling their money from stock market, the report said.
The firm Waddell & Reed, based in Overland Park, Kan., has acknowledged making such a trade that day. . .In that one trade, 75,000 contracts were sold within 20 minutes. It was the largest trade of that investment since the start of the year. . .In a previous statement, Waddell & Reed acknowledged that it had sold the contracts to reduce its funds' risk quickly. It said traders feared that the European debt crisis could spread to U.S. markets.
Single trade worth $4.1B led to May 6 stock market plungeHere's a quick snapshot of what the SEC and CFTC in their report say happened on May 6:
1. Massive sell program is activated. At 2:32 p.m. ET, at a time when the market was already volatile, an unidentified mutual fund company put in a computer sell program of 75,000 E-Mini contracts — these are futures contracts tied to the Standard & Poor's 500 index that allow traders to bet on the direction of the index. The trade was valued at $4.1 billion. Only two trades of equal or bigger size have occurred in the past 12 months, and both were executed by the same unidentified fund company.
2. Trade execution is totally automated. Normally, trades of this large size are executed by a combination of manual orders, sales of big blocks of shares by a trading intermediary, such as a broker, as well as automated computer trades that are put in motion by a computer algorithms. Typically, when computer algorithms are used, these trades target volume, price and time variables.
But this trade was 100% automated, using computer algorithms. It also was designed to feed orders based on trading volume, but not price or time.
3. Trade duration is compressed in short time span. In the two earlier trades of this size entered by this same mutual fund company, the trade was executed using a combination of manual trades placed over the course of the day and several computer-driven trades, all of which took into account volume, time and price. The earlier trades also took more than five hours to complete.
But on May 6, the algorithm-only trade took only volume into account, which resulted in the trade being executed in a super-fast 20 minutes.
4. Size and speed of trade results in too few buyers. By flooding the market with such a big order in such a short period of time, there were not enough buyers to snap up all the inventory of stock futures up for sale. High-frequency traders were the likely buyers of the initial batch of orders. But between 2:41 p.m. and 2:44 p.m. ET they sold about two-thirds of the 3,300 E-Mini contracts they had bought in an effort to reduce risk. At the same time, there was not enough buying by large institutional investors, referred to as "fundamental buyers' in the report, to fill all the sell orders.
5. Selling knocks prices down and causes liquidity to dry up. Selling due to the big algorithm trade by the mutual fund company, coupled with resulting selling by high-frequency and other traders, drove down the price of the E-Mini futures by roughly 3% in a four-minute span ending at 2:44 p.m. At the same time, other traders were driving down the price of an exchange traded fund that tracks the Standard & Poor's 500 index, by 3% as well.
With market volatility skyrocketing, the high-frequency traders began buying and selling E-Mini contracts between each other to limit their risk and exposure in a falling market. The SEC report refers to this trading as "hot potato"-type volume. This quick back-and-forth trading volume, the SEC and CFTC say, only gives the illusion of adequate liquidity in the market, when the reality is that there are few buyers out there willing to put money to work.
6. Buyers of E-Mini futures dry up. With no buyers out there, the value of the E-Mini futures fell more than 5% between 2:41 and 2:45 pm. Sell contracts swamped buy contracts. The level of "net sellers" was 15 times larger than during a similar time period in the previous three days.
7. Five second pause brings back buyers. At around 2:45 p.m., a five-second pause in E-Mini trades was triggered, during which time sell pressured dropped and buying interest picked up. When trading resumed, prices stabilized and shortly thereafter began to recover.
8. Stock buyers disappear too. A brief pause in trading on many of Wall Street's automated trading systems around 2:45 p.m. also gave individual stock traders a chance to figure out what was going on. The report said before trading resumed, traders had to determine if the sharp drop in the market was due to an erroneous trade or some cataclysmic event they were not aware of, and how big an impact the plunge had on their risk levels.
Based on their assessment of heightened risk, many players, including high-frequency traders, withdrew from the market completely. The result: a sharp, sudden drop in prices of individual stocks. Between 2:40 p.m. and 3 p.m., 98% of all trades were done at prices within 10% of their 2:40 value. But with liquidity "completely evaporated" in a number of stocks, some trades only found buyers at "irrational prices" as low as one penny a share.
9. Buyers, armed with better information, resume buying. The crazy drop in stocks, some to as low as a penny a share, was fleeting. "As market participants had time to react and verify the integrity of their data and systems, buying and selling interest returned and an orderly price discovery process began to function," the report said.
10. Prices return to pre-flash-crash levels. Around 3 p.m., most stocks had reverted back to trading at prices reflecting true consensus values," the report said.
Massive computer-driven sell order triggered May 6 plunge 
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