The World's Largest & Most Dangerous Casino: A Machine Driven Stock Market

Most of the day to day noise you hear around the financial markets is just that, noise. Some people spend their days trying to analyze which direction a stock is going to move based on chart patterns or earnings releases to try and "trade" the market correctly. I have repeated countless times that trying to "trade" against Wall Street's machines is like trying to beat IBM's Deep Blue in chess. A waste of time and money.

What happened on Tuesday with the mini Flash Crash, or the Hash Crash, was more than just noise. It perfectly symbolized exactly what the stock market has become and provides a crystal clear preview for what awaits in the future.

A hacker broke into the Twitter account of the Associated Press and posted that a bomb went off at the White House and the President had been hurt. What followed was fascinating.

The algorithmic machines, also known as high frequency trading machines, picked up on this headline and it triggered automatic sell orders. The market went into free fall, a flash crash, as the bids (buy orders) disappeared.

The following graphic from Nanex illustrates this moment beautifully. You can see the market trending along at a normal pace with the machines providing their normal level of liquidity. Then the tweet hits and you can see in the red oval that all bids disappeared. The machines put in their instant sell order (before a human would ever have a chance to react), and then they went into hiding.

This is exactly what took place during the May 6, 2010 Flash Crash, only it lasted much longer and the sell off was far larger. What has changed in the market since that terrifying afternoon when stocks entered free fall for close to 15 minutes? Nothing. There is nothing in place today to stop that from happening again. The only thing that has changed is that these machines now have a far greater control of the total volume.

Wall Street exchanges love them because they have become the main source of their revenue. I have discussed in the past how these high frequency machines loot the markets, and if you have not read the book Dark Pools, I highly recommend you do so.

When you get a firm understanding of how the stock market actually works today, you will see why I repeatedly say that someone trying to day trade the market has a far better chance of winning at the casino tables. This does not mean you should not buy stocks. The market still provides discounts to strong companies that should be bought for a long term cash flowing position, not something that you hope to flip 5, 10, or 15 minutes later.

As a quick example of how traders were crushed on Tuesday, think about those that had stop orders in place before the #Hash Crash. A stop order triggers an automatic sell order when the price of a stock falls to a certain level. When stocks plunged during the 3 minute span it was very likely a trader with a stop order had it triggered. The stocks then bounced back immediately when liquidity came back into the market (the machines saw it was all clear) and that trader was left holding a sell order ticket below where the stock is currently trading. This is just one simple example. I could provide countless others.

One day a crash bigger than what we experienced on May 6, 2010 will occur. The argument for high frequency traders is that they provide liquidity to the market. As just shown above, they provide liquidity to the market when it is not needed. When they are needed to step back in and create a functioning market, the algos sell and then turn off. What will be left after the "big one" is 401k's and many lifetimes of savings that will be destroyed.

More from Rick Santelli:

For much more on this topic see:

Dark Pools: Understanding The World Of High Frequency Trading

Mark Cuban On High Frequency Trading

Dark Pools: The New Dominance Of High Frequency Trading


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