Street Sweep

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FAQ: The stock market's insane drop explained

May 7, 2010: 12:24 PM ET

Yesterday's action in the stock market felt like the equivalent of boarding the commuter train home only to find that for a split second, you were somehow strapped into the Great American Scream Machine. Throughout the day today, Fortune writers will be compiling an FAQ explaining, to the best of our available knowledge, what happened to make the stock market dive almost 1,000 points yesterday, and recover, inexplicably, within 20 minutes. We'll keep updating this point as our staff files, and as more information becomes available.

Questions:

  1. What happened to the market stopper mechanisms

  2. How can I tell if a stock is tanking because of fundamentals?

  3. What's the difference between a legitimate drop in the market (1987) and not (Thursday)?

  4. Did anyone actually buy a stock at a penny a share?
  5. What was the role of the New York Stock Exchange's market makers?

  6. How did this start?

  7. How have high-frequency traders responded?

Answers:

1. What happened to the market stopper mechanisms?


They didn't have to kick in.

After the market crashes of October 1987 and October 1989, the New York Stock Exchange added circuit breakers to halt trading when stocks plunge. If the Dow drops 1050 points before 2 p.m., the exchange shuts down for an hour. If it happens between 2-2:30 p.m., trading halts for 30 minutes. But if a 1050-point dive happens after 2:30 p.m., as it almost did yesterday (at 2:47 it was down nearly 1,000), trading doesn't stop till the end of the day. Trading almost reached halting levelts back in October 2008, but again fell short of the drop needed to trigger the circuit breakers.

Individual stocks have their own breakers. After P&G fell 37% yesterday, the NYSE stepped in and halted electronic trading in the stock. They brought in specialists on the exchange floor to gather prices for the stock and create liquidity. The NASDAQ OMX Group said yesterday it will cancel trades from yesterday between 2:40 p.m. and 3 p.m. in stocks that jumped or fell 60% in the 20 minutes. Here's a list of the affected stocks.

2. How can I tell if a stock is tanking because of fundamentals?

First, check the news. Did the company lower its earnings forecast? Has Congress passed a law that will hurt sales? If traders are reacting to a negative news event, you'll hear about it.

Next, look at the overall market: Are unrelated stocks in different industries falling in tandem? If so, there's a good chance that stocks are being driven down for reasons that have nothing to do with fundamentals.  If the sinking shares belong to companies in the same industry, however, it's possible that the source of their demise is grounded in a real world event. "Often times, you'll see negative news events impact an entire industry, even if it isn't specific to the company," says Ethan Anderson, a senior portfolio manager at Rehmann Financial. Anderson points to the broader drilling industry, which took a hit after the explosion of a BP oil rig in the Gulf of Mexico.

Finally, watch the volume of trades being executed on the stock (you can see volume patterns on Google and Yahoo! finance). If you look at the chart for Procter & Gamble, you'll see that volume spiked incredibly fast yesterday as shares fell. Fundamentals-driven traders aren't likely to dump millions of shares in mere minutes, says Tom Samuels, manager of the Palantir Fund, a long/short mutual fund. "If you're a profit-seeking trader, you don't sell like that," he says. "If you see a huge spike in volume on the downside, that's a clue that it's either a very large shop—which is extremely unlikely—or a footprint of high frequency trading."

3. What's the difference between a legitimate drop in the market (1987) and not (Thursday)?

On Thursday afternoon the S&P 500 dropped almost 9% before recovering. For 15 minutes things felt like pure panic. But it was a lot different than one of the largest panics in market history, Black Monday of 1987, when the S&P 500 fell 20.4% in a day. Think about it in terms of scale: a day vs. minutes, or broad drops versus a number of haywire stocks:

In the week before Black Monday, the S&P 500 was already down 9%. This time around, the S&P was only down 3% in the five days before Thursday. So bearishness was more prevalent in 1987. Black Monday also opened with a slew of sell orders. Many floor specialists couldn't even trade for the first hour because almost no one was buying. It was a broad and day-long selloff.

Compare that with Thursday, when the S&P slowly fell 3% during the day before plunging and recovering more than 5% between 2:45 and 3:00 p.m. Manic selling occurred in a much shorter timeframe on Thursday. Philip Morris International dipped more than 15% in just 15 minutes before recovering. On the Dow, Accenture dropped from $40 to a penny in the same time.

4. Did anyone actually buy stock at a penny a share?

Someone did. Thomson Reuters data shows 19 trades in Accenture stock at 1 cent yesterday. The 100-share blocks were bought in less than 10 seconds. All but one went through the CBOE Stock Exchange, whose electronic exchange was melting down. It couldn't draw any bids so the stock fell to a penny from $41 (and then returned right back to $40). That would be a 400,000% gain in seconds, but the CBOE said it would cancel the trades.

In a panic, orders can bypass the NYSE floor to another liquid exchange like CBOE. But unlike the NYSE floor, where human market makers can halt trading to attract buyers, electronic markets often have few guards.

"Electronic venues do not have these same risk-mitigating structures in place, as computer trading algorithms are designed with the sole purpose of seeking liquidity at any price," Stifel Nicholas analysts Chris Brendler and Matthew Heinz wrote in a note today.

(Ed.: An earlier version of this story incorrectly stated that the lone stock block would have posted a 4,000% gain.  The correct figure is 400,000%)

5. What was the role of the New York Stock Exchange's market makers?

The New York Stock Exchange has five "market maker" firms: Bank of America Specialist, Barclays, GETCO Securities, Kellogg Capital Markets, and Spear Leeds Kellogg Specialists. Their 130 traders are obligated to make a fair and orderly market by buying and selling against trends to dampen volatility. The NYSE market makers mostly trade electronically, except at the open, close, and when a stock is moving rapidly up or down (as was the case Thursday).

The day's sharp declines triggered stocks to move out of automated mode and into auction mode, in which the market makers step in to try to bring in buyers and inject their own capital into the market. A NYSE spokesperson said that for P&G, the market makers kept it from dropping below $56 on the NYSE, while the stock dropped to almost $39 on the NASDAQ.

6. How did this start?

No one really knows yet. But everyone has opinions. Manoj Narang, CEO of hedge fund and high-frequency trading firm Tradeworx has a compelling take that focuses on the role of futures:

"I'm of the opinion that the anomaly started in S&P futures and quickly spread to SPDRs. I think that anomaly probably accounted for a 2% to 3% move maximum in the S&P, and what happened there is quants did what they typically do. They take that price movement in the ETF or index and they propagate that to the individual stocks. It keeps stocks in line with one another and in line with indexes. But when indexes are not priced properly it causes all the stocks to become mispriced also. I think that when some portfolio managers saw the indexes dropping like that, they started panicking because of the economic backdrop and started liquidating."

7. How have high-frequency traders responded?

Again we turned to Narang: "It's certainly unfair but it's not surprising. I think no matter what happens high-frequency traders are going to get blamed. I find it extremely amusing that high-frequency traders are getting blamed for not trading yesterday and causing volatility by not trading when in fact if they were trading certainly the narrative would have been high-frequency traders were causing volatility because of their trading.

"Either way they're going to get blamed. I'd rather get blamed for not trading than for trading because at least that makes it sound like you're indispensable to the market."

-- Scott Cendrowski, Mina Kimes and Beth Kowitt contributed to this post

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