Here’s Why China's Fat Finger Trade Matters

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China's Shanghai Stock Exchange Composite Index (SSE) frankly went a little crazy yesterday afternoon, as shares swung up by nearly 6% - with a 53% jump in volume in a matter of about two minutes.

But it soon came to light that Everbright Securities Co. Ltd., one of the largest securities brokerages in all of China, had placed an erroneous buy order - a fat-finger trade - for securities worth $1.13 billion.

These revelations caused more chaos; Everbright's shares were suspended, while shares of the parent company, China Everbright International Ltd., lost as much as 8.5% of their value. The Shanghai Composite dropped overall.

The volatility ruined a lot of afternoons.

All of this from one fat-finger trade.

At least there was an explanation for the huge moves...

Unfortunately, that explanation shouldn't make you feel any better about what happened. The explanation certainly didn't do much to put Money Morning's Capital Wave Strategist, Shah Gilani, at ease.

He spoke with me about the odd events in Shanghai.

Here's what happened, why it bothers Shah, and why it should bother you, too.

The Real Story Behind China's "Fat Finger" Trade

The China Securities Regulatory Commission reported that an erroneous buy order, for $1.13 billion, placed by Everbright's proprietary trading group, was responsible for the huge moves.

This regulatory finding generally agrees with Everbright's statement that its proprietary trading bureau "encountered problems when using its own arbitrage system." There are - as yet - no allegations of undue manipulation or other untoward activities. Sometimes, a mistake is just a mistake.

One troubling issue is that the $1.13 billion buy order, according to Shah, "isn't all that large... relative to the scope of the capitalization of the Shanghai Composite Index, which averages prices of almost 900 companies with a market value of something like $2.5 trillion."

As large as that order was, it's only a drop in the bucket compared to all the money in play.

The real problem - and unsettling question, as Shah sees it -- is that "the surprise should have been a yawner... That an order of that [modest] size can move the entire index, even if the shares bought were heavily weighted on the index's stocks, is frightening. It says that, no matter how many (and many would have been worse) or how few companies' stocks were bought, the markets can move by that much..."

Shah went on to sketch out a sort of Shanghai nightmare scenario...

Shah continued, "It tells you to be afraid, because for prices to jump and for the index to move that much, sellers must not have been there. Or the sellers walked away to try and sell higher, making the buy orders chase prices higher and higher. What's frightening is that this was on the way up, where you'd think there would be some sellers."

"Just imagine: if there aren't a lot of sellers there to ring the register by selling shares as they appreciate, how many buyers would there be in a panic selloff - especially an extended selloff? If that were to happen, I'd be afraid the index would crash. Regardless of triggers, if market orders keep on coming to sell, markets will crash if there are no buyers. Where were the sellers in this case? Where will the buyers be on the next panic selloff or rout?" Shah asked.

Shah believes that China's fat-finger trade should come as a warning to investors.

"That's what these flash gaps tell us, that there is not as much at-the-ready liquidity in the markets as people think there is. One day, there will be blood."

So, had there been enough ready liquidity, to properly "deal" with the erroneous Everbright trade, we might have had another yawner on our hands.

Instead, we just got a grim look behind the curtain...

If less-than-adequate liquidity wasn't enough to worry about, here's one sign you'd better read correctly if you want any warning about a crash. Click here for this signal.