Retail Traders and Investors get Fleeced by Humongous Banks and Brokers: JPMorgan and BofA Sell High, Buy VERY Low, Sell High Again in Mere Minutes

Thursday's market meltdown and ensuing rally, all of which took place in a matter of 8 minutes will go down as one of the most unethical fleecings of retail investors/traders by the HB&B's ("Humongous Bank & Brokers") in history. Thanks in part (at the least) to high frequency trading algorithms (more about HFT below), between 2:40 and 2:48pm on Thursday May 6, 2010, the S&P500, already down 2% on the day, dropped an additional 6.1%, before dramatically rebounding right back to where it was before the collapse. Of course, the media (namely, CNBC), very quickly (within 2 minutes of this collapse and rebound) came out with "the explanation," that "someone had fat fingers at one of the trading firms, and entered a 'b' for billion instead of an 'm' for million." Give me a break! (See CitiBank Fat Finger, or Stock Sell off May Have Been Triggered by a Trader Error; there are hundreds of additional sources online, just google "fat finger sell-off". Several hours later, conflicting reports out of Fox, SmartMoney, and even CNBC, the source of the original "explanation" came out: Obama Administration Source: 'Fat Finger' Error Didn't Trigger Thursday Selloff and 'Fat Finger' Trigger May be a Myth. ) Again, there are myriad sources that argue in opposition to what I personally believe is an incredibly lame excuse that a single trade at one of the HB&Bs triggered more than $1 Trillion worth of losses and gains in less than 10 minutes (it took 4 minutes for the market to drop and another 4-5 minutes for the market to bounce back to where it was before the meteorite struck).

It is undeniable, however, who benefited the most from this "freak" event. I have managed to get my hands on twenty-five minutes of audio from the NYSE stock trading floor before, during, and after this 8 minute period, which I believe sheds some light on what really happened during the aforementioned time period (nothing short of grand larceny). At the very least, it shows who bought at the absolute nadir of the collapse (Dow -928 points) and sold once the market "returned to normalcy" (Dow -300 points). It gets really interesting just before the halfway point in the audio clip when the anonymous reporter yells: "This will blow people out in a big way like you won't even believe."

Many believe--myself included--that the market does not have the fundamental foundation to support being where it is right now and that it is only at such levels because High Frequency Trading (HFT) or algorithmic trading on the part of hedge funds and the HB&B's have artificially moved it higher taking both the bid and ask prices up in fractional increments so fast that true supply and demand pivots cannot be calculated. In other words, up until several years ago, large stock market transactions required a person to stand up and bid for a certain amount of stock at a particular price and then do the opposite if and when that person or entity was ready to sell. Now, however, with computer trading comes the ability to create a trading algorithm that would trade in place of the person behind the trading account by taking advantage of so-called "inefficiencies" in the market place. This works wonderfully (for the hedge fund behind the computer) when other (mostly retail) investors and traders are willing and able to take the other side of that trade; indeed, it is extremely lucrative under such conditions, which is why when the market is acting "rationally" the HB&Bs are able to rake in the profits. However, when a political or economic event suddenly makes it difficult or impossible to gauge an intrinsic value for the market (the BP oil spill in the Gulf, the uncertainty surrounding Greece's debt problems in the Euro Zone, and the Financial Reform legislation taking place on Capital Hill all qualify) these computer algorithms do not have a counter party to take the other side of their trade and since they are programmed to figure out where inconsistencies exist based on the next bid, they start pounding the market price down until a bid is reached, no matter how far that bid may be. Before HFT, the market would simply have stalled momentarily while the persons behind the trades thought about what was a reasonable bid and ask spread. That moment of reason does not exist with HFT and since it all happens so fast, the market can very easily and quickly feed on itself, igniting fierce downward pressure in market prices that essentially force everyone involved to reevaluate appropriate market valuations. Well, I believe that is partially what happened on Thursday. But wouldn't you know who was available to buy at the exact bottom of this downward spiral, which coincidentally was a few fractions of a percentage points away from the circuit breaker trigger (10% loss) that would have shut down the market for the day: that's right, the proprietary trading desks of JPMorgan and Merrill Lynch (now owned by Bank of America). Just listen to the audio to hear it yourself--note that the recording cracks at various points because of the excitement of the environment. Just keep listening, it comes back.

Computers do what they are programmed to do, and nothing more. If the algorithm behind the trades incorrectly assumes that trading conditions or environments do not change, and therfore does not compensate for "panic" scenarios that inevitably happen in the stock market from time to time, the end result can be catastrophic because the permissions and controls have already been provided to the computer. If you are interested in learning about and discussing the perils of high frequency trading, I highly recommend this prescient post HFT: The High Frequency Trading Scam, by Karl Denninger, which was published on Seeking Alpha two weeks ago.

For those who know what a stop-loss order is, suffice it to say that pretty much every stop order that had been placed prior to this event was hit. For those who do not know what a stop-loss order is, essentially what it amounts to is a great number of individual traders and investors were forced to sell at very low prices, which only became trades in the first place because the algorithms were instructed to "find the next lowest price"--period. Furthermore, it happened so fast that those who were bright enough to figure out what was happening did not have enough time to react.


UPDATE Sunday May 9, 2010: A plethora of news syndicates have finally reached past the implausible "fat-finger" excuse and are actually doing some critical thinking into the matter. Fortune Magazine Online just published an article dissecting what they believe are the most likely possibilities for cause of the flash crash of May 6th, but only after first reiterating my thoughts above:

The fat finger. Plausible, but very unlikely. Typing in billions with a "b" versus millions with an "m" seems impossible. Trading systems don't work that way. More likely, the trading system accepts the sell/buy amount in thousands. Some trader in the heat of the moment forgets it's in thousands, types in an order for 16,000,000 instead of 16,000. That kind of thing seems far more plausible.

Check out the article for more.