Wednesday, May 19, 2010

Stub Quotes Contribute to May 6th Trading Drop

The SEC and CFTC came out with a report today showing their preliminary analysis of the factors leading to the trading activity on May 6th. One of the repeated phrases in the report is "stub quotes." Stub quotes are minimum quotes that market makers put on the other side of trades to "legally" maintain a two sided market for equities. For example, they may put out a Ask quote (Buy Order price) on a stock at $53.75, but instead of putting in a Bid price (Sell Order price) close to the Ask price like $52.75, they instead put in a "stub quote" of $.01. They never expected any trades to hit their stub quote prices. I am sure they thought this was a good way to comply with the other side of the market (Sell side), because who in their right mind would want to Sell their position for a penny a share?

One thing investors who invest on their own need to understand is that Stop Loss Orders will not protect you in a market like the one we experienced on May 6, 2010. I am afraid that a lot of people found this fact out the hard way.

Some people try and protect their positions by putting in Stop Loss Orders. These trade orders are triggered once the price of the stock goes through the stop price. Once it goes through the price, then it becomes a Market Order. In this case, the stub quote for the stock was $.01. So, this meant if you had a Stop Loss Order in at $47, then when it passed through $47, it became a Market Order. This means it goes to the Market Maker at his Sell price! In this case, his sell price was a penny a share! Yikes!!

You may be thinking that this is not fair. The Market Maker in these stocks never imagined a situation where people would be selling at their stub quote prices. Murphy's Law comes to mind here. If there is a possibility that something can go wrong, then it will. In this case, this is what happened.

Think about it from the Market Maker's point of view. If they put out a stub quote of 1 cent a share, then they are actually helping keep the price of the stock up, because this one cent a share Sell price would dissuade investors from selling their stock. They never imagined that what happened on May 6th would actually happen.

The other side of the coin is the shrewd traders who saw these stub quotes and placed Buy Limit Orders. There were several firms that placed orders to Buy these volatile stocks slightly above the stub quote price. For example, they may have placed an order to Buy a stock at $1.00 a share when it normally trades at $50 a share or higher. Since they put in a Buy Limit Order, their orders were filled. Buy Limits are executed at the price requested, in this example, $1.00 a share.

Several of those extreme Buy Limit Orders were filled, but later busted by the SEC. The SEC busted trades that exceeded 60% of their previous 2:40 pm price. However, there were several firms who profited by placing their Buy Limit Orders above the 60% busted trade threshold. In other words, instead of being greedy and putting in their Buy Limit Order at $1.00, they put in their Buy Limit Order at $35 which was within the SEC's 60% threshold. On a $50 stock, they just made a 30% return in a few seconds. These Buy Limit Orders were filled and not busted by the SEC.

You may be thinking that this is not fair either. Well, this is an example of Flash Order Trading. These Buy Orders were most likely not done by some trader at a firm sitting by the computer, but rather by a computer algorithim trading program that is programmed to put in Buy Orders if they see disparate price movements in stocks.

Of course, all the TV pundits are now saying, "..anyone who puts in a market order is a fool." Hindsight is 20/20 I know, but there is no way these TV pundit (idiots in my opinion) knew that a scenario like May 6th would happen. They are just trying to act smart when in reality they are not.

We live in a complicated world today folks. The joint SEC-CFTC report exposes the fact that they cannot trace every single trade order without going to introducing brokers for the information. Personally, I think in order to properly find the culprit, the SEC needs the ability to review every single trade, every milisecond of every single day. Stay tuned, this may take several more weeks, or even months before we see a final report from the SEC-CFTC committee on this issue.

In the meatime, are you sure you want to invest on your own?