What is a Flash Crash?

[Curtis Davis]

[Justin Freeman]

A flash crash is when the price of an asset experiences a dramatic short-term fall from which it soon recovers. Due to their dramatic nature and the considerable impact on traders it’s one feature of the financial markets that becomes of interest to the general public. Flash crashes can occur in any market and at any time. The below chart records the Flash Crash of 2010 that hit the Dow Jones index (and its constituent members). Dow Jones Industrial Average, 6^th May 2010 Source IG Index Within the space of about fifteen minutes the price of the index had fallen close to 10%. A further fifteen minutes later the index price had recovered most of the ground it had lost. At the time there was some concern in the markets relating to the general economic outlook (e.g. the Greek debt crisis) but the extent of the move and the subsequent recovery denote it being a flash crash rather than a market shock. Markets can lurch from one level to another, particularly following unexpected and significant news events. The whipsawing price action that denotes a flash crash rather than a market correction is something that has never been fully explained. Traders, academics, and indeed the regulators have studied the crash to identify the causes but are yet to reach aconsensus. The mechanics of the price move are relatively easy to explain. Taking the Dow Index price chart from 2010. During the first part of the session buyers and sellers are exchanging positions around the 10,800 level. At any one time there will be a bid offer spread.So say for example we are at a moment when the mid-price is 10,802 so buyers are willing to trade at 10,801 and sellers are looking to offload at a price of 10,803. If the number of sellers suddenly increases (or buyers decreases) then the buyers left in the market looking to trade at 10,801 will complete on their trades. Then the next in line, those at 10,800 will get filled and so on, and so on, down through the order book. Let’s assume most of the orders loaded onto the order book at market open were somewhere near current price levels.If those get filled then sellers start hitting what were at the opening of the session ‘out of the money’ bid offers. These can be few and far between; possibly old orders someone forgot to cancel or attempts to bottom fish this kind of event. As prices are printed at much lower levels more participants look to sell, and this becomes a self-fulfilling process. This is why falling markets generally behave differently to rising ones. Crashes are caused by alarm and a sudden increase in sellers that drive prices down very quickly. Buying and investing being seen as a more considered affair. In a flash crash the fact that price recovers quickly raises the question of what caused the initial sell off and indeed if it was done intentionally to manipulate the market. Market regulators including the SEC have conducted significant and high-profile investigations into the situation to try and identify market abuse. One important thing to consider is that Flash Crashes are not particularly new. It could be argued that they are more frequent, and they do indeed appear to gather more publicity. The extra public interest might be explained by flash crashes attracting the attention of those who think ‘robots are taking over the world’ and indeed not doing a very good job of it. It’s true that automated execution can mean that: selling, causes selling, causes selling. There are anecdotes of “someone” having to run to a data center to turn pull the plug out of the wall to stop a rogue machine trading. In general though, most Systematic trading programs now factor into their models the risk of a flash crash style price action. If you don’t believe in ‘fat-fingers’ and trust algo models to have been constructed to account for all types of market events, then you might well start thinking the markets are being manipulated. There is a lot of money to be made and lost during a flash crash. Smaller participants such as day traders are particularly vulnerable to significant losses as larger investment firms with a room full of traders are likely to pick up on the crash happening much sooner than an individual holding down another job. It’s essential to understand the benefits, and limitations, of standard and guaranteed stop-losses. Broker platforms offer that information; it’s just not as glamorous a read as the section entitled ‘Great new trading strategies’ but could be more important to your P&L. Markets do not necessarily behave logically, and Flash Crashes are probably the thing that hammers that point home. Not least because the losses experienced can be significant with entire accounts being wiped out. The hardest question to answer is how to manage stop losses that the rest of the time would appear to be part of a prudent and effective risk management policy.

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