“Yesterday’s fake tweet from the Associated Press’s hacked Twitter account, reporting explosions at the White House that injured President Obama, has sparked renewed criticism of high frequency trading, specifically how some computer traders use social media as an input into their trading strategies.

“Though it’ll be months before we know exactly what happened, the consensus is that a handful of trading algorithms responded to the fake tweet by selling a broad range of stocks, bonds, and commodities. As message traffic spiked and prices started declining, HFT firms started backing out of the market, just as they did during the May 2010 Flash Crash. As a result, liquidity dried up, as you can see here in this chart from Nanex. Since there were suddenly relatively few buy orders to match against all those sell orders flooding the market, the dip picked up speed.

“’When the amount of bids and offers thins out like that, it takes very little volume to move the market in a big way,” says Manoj Narang, chief executive officer and founder of Tradeworx, a Red Bank (N.J.)-based HFT firm. When he noticed the sudden spike in messaging traffic, Narang instructed his traders to back off the number of orders they were sending into the market. “When you’re in the business of posting bids and offers and something is up that you don’t know about, you back off.’

“Within two minutes, the Dow was down 140 points, the S&P 500 index had lost nearly 1 percent, and an estimated $200 billion in U.S. stock market value had vanished. As word spread that the tweet was fake, prices quickly stabilized. A chart of the day’s trading shows a deep, narrow trench carved into the middle—a stab wound, almost.”

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Read full Bloomberg Businessweek article here