What Can Happen When Markets Are Run By Computers? Stock Trading Might Go Nuts Like Today!

This afternoon the U.S. stock market went bananas and I decided to sit down in front of the television, watch, and enjoy myself. When the entire market is run mostly by computers, not only can traders control the minute by minute action but they can even set the computer up so that once certain price levels are reached, their trades get executed automatically, so actual human action is not even necessary. What happens when the computers are overloaded or someone makes a mistake? Well, watch this short segment from CNBC and see how the Dow Jones can drop 500 points and then make it all back in less than five minutes.

This is why many people think short-term trading in the market is nothing more than gambling. Literally anything can happen on any single day, in a single hour or minute, or in this case, a few seconds. Market watchers will tell you to use limit orders as a way to specify your exact desired buy and sell prices to avoid getting taken to the cleaners when markets react violently like this.

The problem with that, of course, is that your order may hit in a moment of panic, and had you known that was happening, you never would have made the trade. Imagine if you came home today to learn that you sold 100 shares of Proctor and Gamble at $50 (a limit order you had set) because it traded there for a brief second based on computer malfunction, but rebounded to $61 within seconds. You would be furious. Limit orders are not always the answer. Investors, especially those who are novices, need to be very careful. As we saw today, the market can be a landmine.

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6 Thoughts on “What Can Happen When Markets Are Run By Computers? Stock Trading Might Go Nuts Like Today!

  1. Highgamma on May 6, 2010 at 7:07 PM said:

    With all due respect, the explanation I have heard is that someone sent down the wrong order. The humans seem to be the problem here, not the machines.

  2. Highgamma on May 6, 2010 at 9:15 PM said:

    Every couple of years we used to hear about someone sending down an order to the Tokyo exchange for some stupidly high priced share for more shares than were outstanding because they accidentally switched the share price and share amount. Finally, the Tokyo exchange got a clue and put in some computer safeguards to keep something like that from disrupting the market.

    Our current market system is such that those types of protections are difficult to implement. In Europe, their automated exchange systems will halt and have an auction to allow for liquidity to come to the market and mistakes to be withdrawn. (I’m thinking specifically of the Euronext.) With our multiple exchange markets, we have more problems doing that. In fact, the NYSE did do a halt and auction, but the other exchanges did not follow suit.

    My point is that (to butcher Shakespeare) “the fault lies not in the computers, but in ourselves”. We need to have sound exchange rules, not computer scapegoats.

  3. While the ‘fat finger’ rumor was going around where someone accidentally entered a ‘b’ for billion instead of a ‘m’ for million would imply human mistake, quants were also involved. Think about the S&P 1094 level around the 200 day moving average. This was a sell trigger for many quants and acted as a line in the sand. Once we hit that level, tons of stops triggered and compounded the wave of selling. The sheer speed and velocity at which it happened was not human, it was quant.

    While we don’t know the full truth yet, it could be a combination of some kind of human error, a possible fund blow up/margin call, and quant algorithms all selling at a certain level. Just a guess.

    Jay
    @marketfolly

  4. Chad Brand on May 6, 2010 at 7:53 PM said:

    One wrong order cannot impact everything in its path. The problem is that the computers are programmed to enter certain orders once certain thresholds are reached. One wrong order (especially in a Dow component such as PG) can trigger the trading systems to go berserk. The high frequency systems fire off thousands of orders in less than one second, which is how the Dow can drop hundreds of points in a few minutes. One look at the volume today (2.5 billion shares) tell us that it was far more than one wrong order. You are right that human error likely triggered it, but humans cannot enter thousands of trades in milliseconds.

  5. jason on May 12, 2010 at 12:22 AM said:

    This is really just scary that in theory a bunch of computers programmed with an algorithm and one mistake by one person can send the market tumbling down…in the past couple of years there has been certainly a few instances that make the American Public question the stability of investing.

  6. Profitable Investor on May 18, 2010 at 9:26 AM said:

    The entire cause of the flash crash was traders from institutions quickly selling, then just not trading again. There was no liquidity in the market, which caused the huge price drop. The same thing happened on Black Monday, as floor traders stopped trading.

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