One of the things many market participants fail to realize is that prices do not require transactions taking place to move. In fact, they tend to move most rapidly in the absence of trades. Why? Because when transactions are taking place it means buyers and sellers have come to at least a temporary agreement on value. Prices move most aggressively when there is no agreement, when one side has to give in to the other and alter its perception of value.
The confusion about all this comes from the fact that the most commonly known exchange price feeds show only transacted prices, not the bid/offer indicative prices which actually underlie everything. Forex traders don’t suffer this problem, of course, as they are used to see an indicative market. Most options traders are also well aware of this issue as thinly traded options can show last trades that are vastly different than the current price at which a trade could be done.
So here’s the deal. When all the buyers disappear from the market – meaning they pull their bids – the market falls until it finds a level at which the buyers are willing to come back in. That means market orders can get filled WAY below where they were expected to be filled. That seems to be at least part of what happened during the market plunge last week.
Here are a couple of good examples (hat tip to Wall St. Cheat Sheet)
“Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid… Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”
John Kenneth Galbraith, 1955, The Great Crash
“I started accumulating stocks in December of ’74 and January of ’75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, ‘Look, Dick, the price is 10, you’re putting in a crazy bid.’ I said ‘Try it.’ Evidently, some frightened investor put in an order to ‘sell GCN at the market’ and my bid was the only bid. I got the stock at 5.”
Richard Russell, 1999, Dow Theory Letters
This leaves one with the very legitimate question as to whether it is a good idea to use market orders or standard stops, which become market orders when their trigger price is met or passed.