May 7, 2010

SkyNet storms Wall Street

Yesterday's wild market ride -- in which stock prices fell into a "black hole" for a few heart-stopping minutes -- appears to have been caused by "black boxes."

Unlike an aviator's black box, which records what has happened, an investor's black box decides what's going to happen. Algos, or trading algorithms, allow investors to program computers to buy and sell when certain conditions are met. For more on algos, see here and here.

For example, if your box was programmed to sell Proctor & Gamble at $58, that would have been triggered yesterday at about 2:45 p.m. Off go however many shares of P&G you held.

Now imagine that happening across whole mutual funds, many of which are index funds that track the whole Dow Jones or S&P 500 indexes. That's how the whole market moved so fast in the same direction.

Thursday's dive seems to have been triggered by an error, but that error led to a series of computer-generated trades that fed into each other until they reached critical mass. The New York Stock Exchange -- which is responsible for less than a third of stock trades in the country -- halted trading briefly, and that seems to have been enough to stop the collapse before it could devour the entire S&P 500.

Buy orders may also have stopped the free-fall, and I would not be surprised if some of the same boxes that had sell orders at one price also had buy orders at a lower price.

Anyone whose black box sold P&G at $58 at 2:45 p.m. only to buy it back five minutes later at $54 made $6 a share today, when P&G closed at $60.

That math has some conspiracy theorists accusing traders of rigging the market. But I agree with Barry Ritzholtz here: There is no need for panic.

But we do need to keep an eye on those black hole boxes.

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