Humans no longer go into battle on the trading floor of stock exchanges. Buy and sell orders have been programmed into machines using complicated algorithms to assess fair market value. Computers make the decisions based on what it perceives to be the correct stock price at that moment and then fires off the orders.
North American stock markets went on a hectic roller coaster ride on Monday and continued throughout the whole week. SEC rules which automatically stops trading for any stock (in the S&P 500) whose price changes by more than 10%, in any five-minute period, didn’t help slow down the selloff.
The Machines Caused a Chain Reaction:
Stop Loss Orders: Program trades are responsible for triggering stop-loss orders. This tends to create very volatile situations because unfilled stop-loss orders automatically turn into “market orders“ which get filled at any price. For example; putting a stop-loss order at 10% on a $100 stock should trigger a sell order at $90. What happens if the stock price skipped $90 and when directly down to $85? Then your stock would be sold immediately for $5 less than planned, even if the stock price bounced back up above $90 a share.
Margin Calls: Falling stock prices can generate a margin call from your broker if one or more of the securities you had bought, with borrowed money, decreased in value past a certain point. You would be forced to either deposit more money in the account or the broker would sell off some of your shares.
Short Sellers: A falling stock market attracts speculators to jump in and add to the selling pressure. They sell securities that they borrow but do not owned. Short sellers are motivated by the belief that declining prices will enable the seller to buy back shares at a lower price to make a profit. However, a sudden stock market reversal to the upside can temporary drive share prices higher because short sellers are forced to cover their short positions.
Market Makers: Banks and brokerage companies help keep financial markets running efficiently because they are willing to quote both the bid and the offer price for a stock. They will buy the stock from an investor at the bid price even if they don’t have a buyer at the ask price. They are literally “making a market” for the stock. However, market makers were driven out of the market this week because they have a limited amount of capital and couldn’t handle the over abundance of sell orders.
The U.S. equity market is dominated by institutional investors. These institutions wanted to do away with humans, wanted completely automated markets, wanted to let the computers and “high frequency” market makers step in and take over. They wanted massive market fragmentation to make the U.S. capital markets “more competitive.” Currently there are 10 exchanges and 60+ alternative venues that do nothing but add to the chaos.
On most days, there are imbalances either to the buy or sell side that could nudge the market’s close in one direction or the other. However, Tuesday’s trading patterns, was an example of how computers generated an avalanche of sell orders on the Dow Jones industrial average and sent it plummeting to a loss by the time the closing bell rang. Keep in mind that there are only 30 stocks in the Dow which really exaggerates price movements.
So, how’s that working for you, the average investor? Does the current market structure allow for fair and orderly trading when the shit hits the fan? I think not!