Explaining The 600-Pt Drop on Thursday: No Liquidity

Posted by urbandigs

Sun May 9th, 2010 10:46 AM

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A: There are two different questions we can ask about the 15-minute 600 point drop in the Dow on Thursday. First, we can ask what was the source/trigger of the selloff after the markets already traded down 3%? Second, we can ask how this can possible happen. I have been in a lot of discussions lately with clients, colleagues and friends about the event and want to try to explain the answer to the second question. I can actually answer it with one word: Liquidity. In this case, a lack thereof.

Recall, that for 8 years I was a NASDAQ Momentum Equities trader with a shop formerly known as Tradescape, Inc., which was bought out by E-Trade and later taken private.

Now, the Manhattan real estate market is built on confidence and needs. When trading markets start to do crazy things, it can ripple into the mindsets of buyers and sellers of Manhattan property. For now, I don't see any general change in confidence outside of people 'talking' about the insanity and volatility of the markets recently. Time will tell how this evolves.

Moving on, you need to know a few basic things about how equity markets work. For sake of ease, I copied a visual of Lehman's Level II Stock Quote from a discussion on "Massive Deleveraging" back in September of 2008; kind of fitting to use a IB that no longer exists.



Think of every stock as having two towers; a bid tower (left side tower) and an ask tower (right side tower). At any given point in time, there is an Inside Market that consists of the highest bid & the lowest ask.

Underneath the highest bid (top of the left BID tower) and the lowest ask (top of the right ASK tower) are the supporting bids and offers waiting for the market to reach them. At any point, these bids and offers can be removed by whomever is supplying them. In this case you can see the bids in LEH going down to $9.24 and the offers in LEH going up to $9.52. Although you can't see more, the towers on both sides continue with bids and offers all the way up and all the way down. The market makers and the ECNs (electronic communication networks) are the players that you see in the snapshot above; who basically make a market or provide for a medium of electronic exchange in all securities. These are the guys that are providing for liquidity at any given moment in time for all securities. When I was trading the most popular ECN by far was ISLD (Island ECN), followed by INCA (Instinet), and BTRD (Bloomberg Tradebook) and the off market system of SelectNet.

The Event Thursday - Putting aside the actual cause of the event, what I can tell you is that what normally are very liquid markets immediately became Illiquid the moment traders, HFT boxes, market makers, etc.. figured out something was going on. As a result of this uncertainty and confusion on the downside of the event in an almost panicky manner, bids for most securities were PULLED OUT in essence causing the tower of bids to crumble down upon itself. Looking at the snapshot above, imagine if all the bids under the inside market just disappeared all at the same time; including all the bids below what is shown! That is how the markets plunged 600 points in only a few minutes.

As the markets figured out it was some type of glitch not warranting the move that just occurred, the reverse happened. That is, all the offers were removed in the tower of asks as the equity re-priced itself back to the level it was at before the event. The entire event lasted about 15 minutes as volume tumbled - proof positive of what happens in stock markets when liquidity disappears. Those that were able to pull of trades were either very happy or very upset.

Volume tumbled during the 15-min event because there were NO BIDS TO HIT on the way down and NO OFFERS TO TAKE on the way up. It was utter chaos and something I saw a few times during the course of my trading career. I recall the EMLX hoax back in August of 2000, that basically took the stock down from $104 to $43 in a matter of minutes - the bids basically disappeared as the stock became illiquid and tumbled a few points every 10 seconds until the halt. The stock re-opened around $112 or so later that day and a trader across my desk (known as Big Daddy for his risk taking and cahones) pocketed $400,000 because he loaded up on about 6,000 shares between $50 and $43 before the halt (one of the few traders providing liquidity when nobody else would) - losing around $25,000 before the halt but making $400,000 when the stock reopened. NASDAQ let the trades stand and sucks for those that hit Big Daddy's bids!

Back to the event. Putting the cause aside for a moment, what you guys witnessed is what happens when the stock markets become illiquid. Scary? You bet ya. This is what happens when investors panic and sell into a market with no bids. This is how an index can plunge 6% in 6-7 minutes and rally back in another 6-7 minutes on virtually light volume. In a world of dark pools, high frequency trading algos, and massive institutional trades, it is proof positive that outside forces can trigger markets to become highly illiquid at any time. The structure of these markets are supposed to correct themselves when there is a mis-pricing and always provide for liquid markets - we now know there are flaws in this structure.