The "Halting" Truth of a Frozen Nasdaq

From the Editor: Losing access to your money is frightening, no matter how long the powerless state lasts. But when investors in more than 3,200 public companies lost contact with their Nasdaq-listed shares Thursday, we caught a glimpse of something far more troubling. So here's Shah with what this all means for "our once shining city on the hill."

If Goldman Sachs can lose $100 million in a matter of minutes on account of its computers misfiring, is that a sign of things to come? Or is it proof we're already there?

You heard about last week's shutdown, but do you know what it means?

On Tuesday morning, Goldman Sachs let its computers run; too bad for Goldman they got out of the corral and ran wild.

Within 17 minutes after the markets opened, the damage was done. By some estimates, Goldman could lose up to $100 million.

The final body count - in terms of whether it will affect one or five employees' year-end bonuses at the trading behemoth - depends on whether Goldman will be held responsible for its errant trades, or how many of them will be canceled, or whether they might have to make other traders whole for the black hole they dug for them.

It could have been a fat finger, or it could have been a ghost in the machine, or it could have been a window into the reality of high-frequency game theory and its application.

I say it was the latter.

And here's why it matters, to all of us...

There are too many lean and mean traders and pointy people in general at Goldman for it to have been a fat finger. The only thing that's fat over at Goldman is their bonus checks.

A ghost in the machine? Nah. When your existence is overseen by "spooks" (that's the name insiders call CIA operatives, and once a spook, always a spook), it's impossible to not have ghosts in the machines, in the hallways, in the underground offices protecting their building and operatives worldwide.

Here's everything you need to know...

Goldman's computers sent "expressions of interest" - that's what the Financial Times called them, based on its interviews - down to the exchanges. (I'll come back to expressions of interest, and you'll see them for what they really are.) However, the expressions of interest weren't what was transmitted. What got fired instead were real orders.

The orders were to buy and sell options.

Of the estimated 400,000 contracts on 51 different stocks that got executed, and of the 500 biggest orders, 405 orders were sent down on targeted stocks whose tickers start with the letter H, I, J, K, or L. Of those 405 orders, some 130 orders were for 1,000 or more contract lots each.

In other words, this was some type of "program."

The options prices at which Goldman ended up buying and selling were so far outside where the options were actually trading that they lost a lot of funny money... maybe 100 million shekels.

For example: At the open on Tuesday, some iShares Russell 2000 ETF options were changing hands at $3.32; Goldman came in two minutes later and sold a chunk of those options at $1.00; a minute later they were back trading at $3.32. Now, that's a trade I wish I was on the opposite side of. Imagine buying 1,000 options contracts at $1.00 (thank you, Goldilocks) and selling them in a few seconds for $3.32!

So, you can see how the outcome for Goldman was such a huge loss on the day.

And of course, Goldman knows how much $100 million a day is.

Why, just back a couple of years ago, after the crisis in 2010, Goldman earned at least $100 million a day from its trading division on 116 out of 194 trading days through the end of September. The firm lost money on just one day during the three-month period ending in September, federal regulatory filings showed. So a $100 million losing day? SHOCKING!

Goldman will get a bunch of the errant trades it lost money on canceled. It will lose money on others.

What matters, what is hugely important, is this:

You just got a glimpse of what happens behind the scenes.

Let's talk about that "expression of interest" thing. That is a ridiculously insulting way of characterizing the bids and offers Goldman sent out. What they were doing was sending fake bids and offers or pinging the markets to get market-makers and traders to move their quotes to trigger trades.

It's about program trading in the high-frequency trading universe.

It's game theory in action. And it's a dangerous game.

Why on earth would Goldman send an order to sell the iShares Russell options for $1.00 when it's trading at $3.35? Of course they wouldn't! They never meant to send real orders. They were supposed to be sending expressions of interest, or manipulative bids and offers, to shake out free-money trades. How else do you make $100 million a day for almost 116 days in a row?

For heaven's sake, I've been screaming about the dangers of high-frequency trading for years. I've written about it at Money Morning innumerable times (here, here, and here), for Forbes, over at The Wall Street Journal's MarketWatch. I was actually talking about it on Fox's Varney & Co. the very same day this all went down. (You can watch that interview right here.)

Even worse, Goldman isn't the only ghost out there. There are a lot of them rising up from the graveyard we used to call our capital markets, our former free markets, our once shining city on the hill.

So if Goldman Sachs can lose $100 million in a matter of minutes on account of its computers misfiring, is that a sign of things to come? Or is it proof we're already there?

You don't have to look further than the Nasdaq "freeze" two days later for the answer to that.

Tomorrow: Three ways to protect your money before the next "freeze," from Chief Investment Strategist Keith Fitz-Gerald.