#Panic: What to Make of the Twitter-Induced Market Plunge

Algorithm-based trading once again in the limelight.

Algorithm-based trading once again in the limelight
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A Twitter-induced panic that briefly rocked financial markets last week has prompted fresh criticism of algorithm-based trading and its potential to rapidly destabilize stock prices.

Last Tuesday, the Associated Press sent out a tweet indicating that two explosions had gone off in the White House and that President Obama had been injured. Although it did not take long to verify that the tweet, which was the result of the AP's Twitter account being hacked, was false, it's what happened during that brief period of uncertainty that has investors concerned.

[Read: Why Your Mutual Fund Provider May Start Blowing Up Your Twitter Feed.]

In a matter of minutes, the Dow Jones Industrial Average dropped by around 145 points. Put another way, approximately $136 billion in wealth vanished into thin air, only to reappear moments later when the truth got out and trading stabilized.

Jeff Kleintop, the chief market strategist for LPL Financial, says that the plunge highlights some of the vulnerabilities of trading stocks in a high-tech world. It used to the case, Kleintop notes, that the worst that could happen was "you could get a fake press release on an individual stock that could dislocate its price." Now, of course, things are different. "We're now at the point where you can just Twitter-bomb the entire market with a single post," he says.

While humans were the ones who ultimately verified the falsity of the AP tweet, computers were largely behind the market dislocation that took place in the interim. Trained by algorithms, computers can search headlines and social media and make trading decisions based on what they see. These computers, which make their decisions in a matter of nanoseconds, were fooled by the fake tweet.

[Read: Does High-Speed Trading Hurt Investors?]

The ability of a hacker to have such a large effect has many in the investing community worried. "To me [that would sound] like we have a real vulnerability in that trickery can induce [panic]," says Jeff Tjornehoj, the head of Americas research at Lipper. Or, as The Economist put it, "a market sent skittering in one direction and then another because of false signals does little to provide information or [instill] confidence."

Tjornehoj notes that algorithm-based traders do not even need to sell stocks to cause the type of panic that ensued on Tuesday. In fact, he notes so-called high-frequency traders can cause a plunge merely by refraining from buying stocks, thereby triggering a liquidity crisis. High-frequency traders "weren't necessarily selling" during those moments, he says. "It's more likely that they weren't buying."

[Read: 6 Tips for Twitter's IPO: How Not to Be a Facebook.]

The aftermath of the Tweet prompted introspection on Wall Street and quite a bit of ridicule on late-night television. "Now, for investors like me, it was a real roller coaster ride," Stephen Colbert said on "The Colbert Report." "And I still can't believe I blew $16 for the souvenir photo."

Nonetheless, some see a silver lining in the fact that the market stabilized quickly in the aftermath of the tweet. "I also think the recovery from it shows that [the market is] perhaps resilient enough to overcome the trickery that some may play," Tjornehoj says. "It didn't take but a few minutes to normalize. So I think the end result is that ... it passed relatively quickly, but it leaves us less certain that the next time we will overcome [in the same way]."