You Can’t Handle The Truth!

| October 13, 2010 | 0 Comments

Where were you the morning of May 6, 2010?

Let me refresh your memory…

It was the start of a turbulent trading day.  There was some bad news out of Europe, and the markets were acting weak.  This was nothing out of the ordinary really, just some heavy selling activity.  Nothing the markets haven’t seen before.

But what happened next was far from normal…

The markets started dropping… and fast.  It wasn’t long before the Dow was plunging 500… then 600… then 800… At one point, it was down over 1,000 points!

It was a market crash happening right before our eyes.

I remember sitting at my desk watching my trading screens in disbelief.  Had something happened?  Was there a terrorist attack?  I was waiting for the breaking news to come across the TV… but it never came.

And after being down over 1,000 points, the markets rallied.  The Dow proceeded to climb over 600 points, ending the day down a little over 300 points.

It was an exciting, perplexing, and unsettling day all rolled into one.  At the end of the day, I was wondering what the heck happened.

And I’m sure you were too…

May 6th was the infamous “Flash Crash”.

It left many investors shaking in their boots.  And even worse, it’s causing many investors to pull money out of the stock market permanently.  Investors’ trust in the markets is shattered.

And now, after their investigation into the crash, the Securities Exchange Commission (SEC) has pointed the finger of blame!

And they’re pointing the finger at a small Kansas-based trading firm, Waddell and Reed.  The SEC thinks this firm caused the biggest one-day point sell off in history.

Come on, you’ve got to be kidding me!

What’s going on over there at the SEC?  There’s no way Waddell and Reed sparked the sell-off that caused the flash crash.  By looking at the facts, you’ll see the SEC’s blame is misplaced.

In a nutshell, here’s what happened…

Waddell and Reed sold 75,000 S&P e-mini futures contracts that day.  A large order, but nothing out of the ordinary.  The order was a hedge to protect a portion of their $75 billion investment portfolio.

The SEC claims the manner and timing of this sell order initiated the crash.

But according to the Chicago Mercantile Exchange (CME), this explanation doesn’t hold water.  And I agree with them…

The CME is where the e-mini futures contracts in question are traded. Here’s what the CME has to say:

“…the orders, as well as the manner in which they were entered, were both legitimate and consistent with market practices.”

The CME went on to say:

“These hedging orders were entered in relatively small quantities and in a manner designed to dynamically adapt to market liquidity by participating in a target percentage of 9% of the volume executed in the market.”

In other words, although large, there was nothing unusual about the trade or the way it was entered into the market.

The CME also goes on to say the 75,000 lot order was a mere 1.3% of total E-mini volume on the day of the crash.  (If an order for 1.3% of total volume is enough to cause a crash, well then, we’ve got bigger problems…)

Also, other market participants did not know the size of Waddell and Reed’s order.  So there’s no way other investors were selling because of it.

But here’s the real kicker…

The CME says the majority of Waddell and Reed’s order was filled after the flash crash had already occurred.  That’s right, over half of the 75,000 lot sell order was executed as the market rallied later in the day!

Yet the SEC is still pointing the finger at Waddell and Reed!

What was the real cause of the crash?

In my opinion (and many others), HFT computers are the root cause of the crash.  These supercomputers went haywire.  And since HFT now accounts for the majority of the volume on the exchanges, the results culminated in a “flash crash”.

The real effect of HFT computers by now should be obvious.

They’re dangerous and unnecessary.  They add no value to market structure and are in fact harmful in certain situations.

Some say they add liquidity to the markets.  That may be so, but as we saw on May 6th, that liquidity dried up when it was needed most… when the markets were falling hard.

The bottom line is this…

The events of May 6th scared many investors out of the stock market.  To regain their trust, it’s time the SEC pulls their head out of the sand and puts the blame where it’s appropriate… on HFT trading.

Only then will investors feel confident about putting their hard-earned money back to work in the markets.

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Category: Stocks

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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