First off, if you've missed my prior posts on the Crash of May 6th, please take the time to check them out now. There is also ample valuable information from knowledgeable readers in the comment threads. They are well worth your time to read through.
Now, where do we go from here? Senators are already calling for investigations and studies, and there will be talk about increased legislation and regulations. Here are my suggestions.
1) IF the NASDAQ wants to cancel trades that are at "crazy prices" - to use the subjective term - and I think it's beyond debate that they do want to cancel such trades, since they already demonstrated such, THEN steps should be taken to prevent these trades from taking place in the first place. There is no reason to allow these trades only to cancel them after the fact. If you want to protect traders from themselves, then PROACTIVELY make sure that the trades can't get printed unless people really want to trade at those prices. Institute market wide individual stock based trading curbs, perhaps similar to the NYSE Liquidity Replenishment Points, but make sure that they apply to price increases as well as decreases, and make sure they aren't structured to attempt to prevent stock prices from falling. We should not try to prevent lower stock prices via legislation! We SHOULD try to prevent "abnormal" trades - if we want to protect traders from themselves.
2) Who are we protecting anyway? I think it's widely agreed upon that no one wants to see professional investors bailed out of computer trading algorithms run amuck. If a crazy computer algo takes a stock from $30 to 1c and then back to $30, who cares? Investors shouldn't care - if you didn't read the news or watch TV intraday, you might not even know that the stock moved! Your portfolio value is unaffected. Traders should absolutely LOVE it! If there are crazy computer algorithms in the market doing crazy things, guess what, that makes it much easier to make money! We rational humans can outsmart algo's gone wild with ease, right? The first thing I did Friday morning was enter a bunch of lowball bids in a number of stocks, PRAYING for a repeat of whatever happened on Thursday.
Of course, retail investors who lacked a true understanding of what they were doing got plugged on stop orders, which turned into MARKET orders when their price level was triggered. One claim is that trading activity like this makes people "lose faith" in the market. Don't lose faith in the market - lose faith in market orders! I like that credo. Please join me here at Kid Dynamite's World in declaring war on market orders. One commenter on Ritholtz's blog sarcastically noted, only semi-sarcastically, I think:
"I would always advise people against entering stop losses that become market orders. Perhaps it’s those type of orders that should be banned. Should I call my Congressional representative to try and enact a law to stop those people who use them from hurting themselves? Do you advocate that?"
I strongly agree with that sentiment, and noted that there's really no reason why we couldn't ban the "market" order type. Really. There's no reason why anyone should ever use a market order. None. In fact, BATS exchange automatically adjusts all incoming market orders to limit orders, where the limit is the greater of 50c or 5% of the stock price: higher for buy orders, and lower for sell orders. Just a little bit of built in protection. So, related to that point:
3) Brokers, especially broker catering to retail investors, should step up their client education platform IMMEDIATELY. It's in their own best interest, obviously. I'm sure Etrade doesn't want to have to explain to a client why their sell stop order in ACN got filled at 1c. They make you demonstrate experience or investment competence to trade options, and they should do the same with market orders and stop orders. If we want to protect investors from themselves, and again, I think it's been demonstrated that we do, we should educate them and make sure that they have all the information they need to make an intelligent, responsible decision. If someone wants to enter a stop order, they need to be certified to do so - this really isn't a big deal - the SEC could design a 5 question quiz demonstrating that when you enter a sell stop order at a price of $30, you understand that you can get filled at $30.25, $30, $29.99, $15, or 1c. Investors need to understand this, and we need to continue to remove "excuses" from our markets.
4) Should we ban "high frequency trading" ?? I certainly don't think so. As I've noted in my previous posts: of course the increased speed and technology of our modern markets contributed to the severity of the crash - but aberrations due to technological quirks are quickly self correcting (as we saw!) - stocks bounced right back. When fast cars crash, they do more damage than horse & buggy crashes - but we don't ban automobiles.
One reason I included the tremendous audio from the S&P Futures Pit in Chicago is that it's an old school market with no computers. The same people who blame high frequency trading for dominating markets also blame them for walking away! (the Wall Street Journal wrote an article stating as much, and others have expressed similarly confused views) Well, non-HFT liquidity providers had ample opportunity to step in and show how much better they were when the HFT guys turned their systems off right before the big downdraft (please read PeterPeter's comment about why HFT guys did this - it's due to problems they were seeing in being able to accurately process information on time). The S&P futures pit audio shows that there was massive illiquidity there also - in a non-computerized, old school market with traditional liquidity providers. No one wants to step in and get run over when markets crash. Computers/no computers/stock/bonds/commodities - it doesn't matter. When markets crash, they crash hard and fast. You can't regulate or legislate that behavior away!
5) Let's not forget something - prices got crushed because there were more (or more aggressive) sellers than buyers. It's not because machines wanted to destroy the world, or because the markets are manipulated. I think the decline was long overdue, as the massive previous rally in the markets was based largely on forced investing, goosed and fueled by the Fed in the way of zero interest rates. Investors demand return - they need return, so they sought out risk assets in a way very similar to the bubble we're trying to recover from - buying across asset classes in a manner I thought was reckless. When you buy because you HAVE to be a part of the party, you have a quick trigger on the way out - you don't want to be the last one holding the hot potato. Throw in a dose of pure economic disaster and contagion brewing in Europe, and you have all the ingredients for the perfect storm.
I use the term Ponzi scheme a lot on this blog, and markets designed to go higher based on the need for more buyers participating rather than fundamental improvements are also destined to crash hard when the buyers disappear. On Thursday May 6th, the buyers disappeared and the sellers wanted out.
To summarize - it wouldn't be hard to institute reasonable individual stock trading curbs to slow down markets a bit in times of extreme stress. It would also be a noble goal to try to continue to educate retail investors who don't know what they are doing, so that they can avoid trades that result differently than they had intended. I think trying to legislate away market movements is impossible, though, and that minimal intervention is needed: after all, this crash was a long time in the making.
There's a saying: stocks take the stairs up, and the elevator down...