Dow Jones 1000 Point Drop - What really happened?

Pundits, analyst and government officials still don't seem to understand what I knew at about 2:50pm on Thursday 06 May 2010. The Dow Jones Industrial Average and, more importantly, the entire stock market functioned just as it was intended and in the exact manner that participants in that market demanded.

To better understand how the market moves it is necessary to know what factors move the market. Primarily it is fear and fundamentals. First, a quick summary of the fundamentals.

In a sense stocks are bought with borrowed money. Literally, there is what is called margin trading. This is where money is borrowed against the stocks currently owned which allows the trader to buy more stocks. In a broader sense though money is borrowed from that parked in bonds. Bonds are a liquid asset where the cash is available and pays a return, interest, on the money invested.

If that money is transferred to stocks the cost to own the stocks is what would have been earned in interest. So generally, when interest rates go up stocks will go down because there is less incentive to own stocks which have a reduced spread. The spread is the difference between the interest rate paid on cash and the dividends and anticipated price appreciation of stocks.

The other market driver is fear. This comes from two polar opposites. Fear of losing money and fear of not making money. When the market starts to decline and then accelerates, investors as a group begin to fear losing the value in their portfolios which is the term for their collection of stocks. Some people anticipate these declines and "short" a stock. Shorting is when a trader borrows a stock from someone else and sells it, betting that the price will decline.

The other side of fear is that of missing out on a rally or getting in on it too late. The short seller doesn't want to get in on a rally late as that means it will cost him more to buy back the stocks that he borrowed and sold earlier. Likewise investors don't want to pay more than necessary for stocks. Either of these can push the market up nearly as quickly as it goes down.

An interesting dynamic about stocks is that only about 1-2% of the outstanding shares in a company will trade in a day. Even when a stock changes 10% or more in price it is usually no more than 3% of the outstanding shares trading. This is because most investors don't consider buying or selling their stocks on any particular day. They are "buy and hold" investors.

I am what is called a "pattern day trader". I buy and sell stocks with little intention of ever holding onto them longer than a few minutes to a few days. I exist in the market for no other reason that to provide market stability. To explain what went on during the dramatic decline and rebound I will give an example of how traders play the market.

To start you need to understand what a "limit order" and a "market order" is. A limit order is an order to buy or sell at a particular price. A market order is an order to buy or sell at whatever price is being offered or asked at the moment. In my example I will use XYZ company which is priced at $100 starting the week.

By Thursday the value of XYZ was down to $95. Everyday, traders put in limit orders which can be seen as "bid", the price that a trader wants to pay, and "ask, the price a trader wants to get. Those can be seen here. As you can see there are not many limit orders placed and if you watch for a few minutes you will see it changing often.

Another type of limit order is a stop-loss order. That is the price at which an investor wants to get out of a stock and "cut his losses". So in my example let's say there are many stop-loss orders placed in the range of $60-$90. That means, when the stock price gets down to $90 the guy who is only willing to lose 10% has already programmed a computer to sell the stock.

So start off, the day opens with some fear about the market in Europe possibly going into free-fall. XYX opens the day with not many people wanting to buy. In fact, there are no 'bids' over $91. The highest bid prices are quickly filled by sellers who decided to start the day with market sell orders. That is they wanted to sell at whatever the price was. Since there was a bid of $91 that is where the market started.

As the day wore on the price dropped below $90 and the stop-loss orders started getting triggered. This put more downward pressure on the market. Buyers were being cautious and not wanting to buy until they knew for sure that the market had stabilized. In the meantime nervous sellers just wanted to get rid of what they owned before the price went any lower.

By early afternoon prices were dropping even more and, as news spread of the declines, more stop-loss orders were being placed, and buyers were reassessing the "bids" they had placed. The result was that there were few bids in place and more people wanting to sell. XYZ was down to $80 at this point, triggering more sell orders.

Bids were now being lowered from $75 to $60, $50 or something silly like $10. As that market started to fall quickly the stop-loss orders were automatically triggered. Panic set in and some sellers simply demanded that their stocks be sold. In a matter of minutes the $75, $60 and $50 bids had all been met by market sell orders. Even so panicked sellers kept placing market sell orders.

Before news could get around that XYZ was now at half price, investors kept saying to sell. Often times "saying" to sell through a pre-programmed trade price that may have been set months earlier like when the stock was at $50 and a stop-loss of $45 was placed. As buyers started trying to choose between stocks, sellers kept placing orders. In the two minutes it took the buyers to start placing orders XYZ went from $50 down to $10. A few minutes later it was back up to $70 as buyers overwhelmed the market with market orders as quickly as the sellers had.

Part of the reason that prices fluctuated so dramatically was because of rules in place on the major exchanges. If the prices go down extraordinarily the major exchanges have pauses. A seller still intent on selling is moved to an off-exchange site where buyers are not as prevalent. The market price on the exchange could be $25 but $10 off-exchange. In the 15 seconds that the exchange may have been shut the "market" order was shifted off exchange. This is why limit sell orders must be in place.

On Thursday I made some very careful buying decisions in the morning based upon prices being about 10-15% lower than what I had sold them at the previous week. In that period between 2:40pm and 3:00pm I saw an ETF that I trade, URE, go from around $40 down to $3.24 and back up to around $40. I only use one computer and do this part-time while reading e-mails, writing articles and doing research. So it took a moment for me to get the news.

I saw that URE was under $20. I went to place the order and was given a quote of $3.24. I thought I had entered the wrong symbol. I clinked the link and was taken to a chart where I confirmed that I had entered the correct symbol. Normally I would think the company had just announced a bankruptcy filing but this was an ETF [Exchange Traded Fund] made up of 20 or so companies. So, I decided to buy. The price was around $32. I place the order to buy at 'market' price and bought it at $35.11. A few minutes later it was $40. So then I placed a market sell order.

That order took 12 minutes to execute. It was excruciating but as the price was going up I didn't mind so much. It hit $42 but then started drifting lower. Finally, I got $40.60 out of it. The exchange later canceled all orders executed while the price was under $16. So, it was actually good that I didn't pay $3.24 because I would have made nothing once the trades were canceled.

Rumors abound as to what caused the near free-fall in stock prices on Thursday. Some have speculated that one trader inadvertently entered a huge sell order. Others say that computers gained intelligence and did it on their own like something out of a sci-fi movie. Still others speculate that it was a deliberate manipulation of the market by wealthy traders.

In the end it will be resolved that the markets responded to the pressures applied by panicked investors just as they were directed to do.

In closing, I will give you an example using Superbowl tickets. Let's say it looks like the two most popular teams in the league are going to win their playoff games. That would increase demand for the tickets. In the final minutes though unknown teams from small markets score touchdowns and move ahead in each game. Normally tickets are sold through brokers on-line or in newspaper ads. Scalpers suddenly panic and flood the brokers with offers to sell and the price goes down dramatically as some brokers quit buying.

This is just like what happened on Thursday when the pool of buyers on the major exchanges evaporated and the majors shut down their computerized trading systems briefly.

Now imagine that you run out onto the street in front of your office building and say "I'll sell these Superbowl tickets to the highest bidder in the next 15 seconds". That is what happened Thursday. Impatient sellers who volunteered to play in this stock trading game suddenly decided that they were willing to sell to anybody at any price regardless of how insignificant the market was.

If you want to play a game that occurs in micro seconds on various exchanges throughout the world then it is best to first do your homework, know the risk, not panic and USE LIMIT ORDERS!


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