It’s Not the Same Old Market

05/24/2010 10:44 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

This is not your father’s—or mother’s—stock market. 

And if the action of the past few days didn’t convince you that volatility is here to stay, then go hide in a mutual fund and check your net worth once a quarter. 

In fact, that’s probably good advice for most ordinary investors who are simply trying to build long-term retirement security. If you’re going to have a proverbial heart attack every time you check stock prices on your computer screen, the stress will kill you long before you reach retirement. Ever wonder why you don’t see many gray-haired traders? 

As much as Congress may wring its hands and consider nonsensical trading restrictions, we can’t put the genie back in the bottle or—in this case—the silicon back on the chip. Traders will always seek faster access and more powerful programs.

So, it makes sense for the Securities and Exchange Commission to try to inject some reason—or at least a pause for reason to reassert itself—into what has become a predominantly electronic market system.

The concept of “circuit breakers” was first created as a response to the stock market crash of 1987. That regulation set “triggers” to temporarily halt trading if the Dow Jones Industrial Average fell 250 points, and again if it fell 400 points. 

Over the years, those “triggers” were re-set, reflecting the higher value of the Dow and the increased volatility of the markets. And they’re still in effect.

Currently trading is halted on the New York Stock Exchange if the Dow declines ten percent—or about 1,000 points, since we’re trading at the Dow 10,000 level these days. The amount of time the market is closed depends on the time of day the incident occurs.

Additional circuit breakers are triggered if the Dow falls 20% or even 30%. In the latter case, the New York Stock Exchange would close early for the day. Notably, these circuit breakers apply only in a falling market; there is no restriction if the Dow rises quickly.

So, what happened a couple of weeks ago? Why didn’t the circuit breakers kick in when the Dow fell nearly 1,000 points in just 20 minutes during the “flash crash”?

Well, the first and most obvious reason is that it didn’t reach the required ten-percent decline that day. But the unprecedented drop also revealed a problem of electronic market coordination

As sell orders flooded the market, NYSE officials delayed trading for about 90 seconds—an eternity in today’s fast-paced markets. 

But the mandated national market system required orders to be electronically routed to whatever bids existed on the dozens of electronic exchanges. Those bids were thin and thinner—posted only because of a requirement that some number appear on the bid side.

If you thought old-time NYSE floor specialists were chicken in a crash, those electronic bids for a few round lots disappeared in a flash. (Thus, the term “flash crash.”)

Now, exchange leaders have proposed a solution ahead of any SEC regulations, which could take months. It would require all exchanges to participate in new circuit breaker rules that applied to individual stocks as well as indexes.

Basically, if a stock moved more than ten percent in a five-minute period, there would be a temporary, five-minute trading halt. During that period the listing markets such as NYSE or Nasdaq would issue the first quote or transaction to reestablish an orderly market. If the markets can’t establish a quote after ten minutes, electronic trading would resume at whatever prices the electronic markets set.

These new individual stock circuit breakers would apply on the up side as well as the down side.  So, a “melt-up” would be impacted as much as a “melt-down.”

Will this make the markets “safer”? That’s what investors want to know, and that’s the effect the officials want to achieve. But you and I know that the stock market is always risky—and always has been. 

Only a generation raised to believe in “entitlements” could scream about stock market volatility and believe they are entitled to have “safe investments.”

Yes, the market might appear “safer” as a result of these new circuit breakers, scheduled to go into effect in mid-June, because they will at least temporarily halt precipitous slides. 

But markets still trade on emotion—and even computer programs reflect both the fear and the greed of those that set them in motion. No exchange regulations or government edicts can change that.

Full disclosure: I serve on the board of directors of CME Group (Nasdaq: CME), which operates exchanges that offer futures, options, and other trading and hedging vehicles.

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