Flash Crash 101

What Causes these Rapid Stock Drops and How They Can be Avoided

Flash Crash 101
January 5, 2015

On May 6, 2010, the S&P 500 suffered what has since become known as the Flash Crash. The market was already down about four percent that day, due to fears about the European sovereign debt crisis, when it suddenly plunged another six percent in a matter of minutes. Then it reversed course and rebounded almost as quickly as it dropped.

This dizzying ride left traders and market watchers scratching their heads and wondering, what the heck had just happened? It turns out that high-frequency computerized trading was the main culprit of the Flash Crash. U.S. regulators concluded that the Flash Crash occurred when high-frequency traders halted activity following a huge trade by a single market participant.

A report from the Securities and Exchange Commission (SEC) and the Commodities Future Trading Commission stated that, “While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time.”

Mini Flash Crashes Are Also Damaging

Since the big Flash Crash four-and a-half years ago, other mini flash crashes have also occurred with individual stocks. On August 1, 2012, a disruptive episode referred to as the “Knightmare” occurred when Knight Trading made a series of trading errors that resulted in more than 200 mini flash crashes during the first fifteen minutes of trading. Since then, there have been four instances when there were more than 100 mini flash crashes during the market's first quarter of an hour — including October 15, 2014, when there were again nearly 200 mini flash crashes during the first fifteen minutes of trading.

Most recently, Apple suffered a flash crash on December 1, 2014, when its stock fell more than three percent in one minute and ultimately dropped more than six percent before rebounding to close down about three percent. One possible reason cited for the Apple flash crash was computerized automated program selling.

On the other hand, there might also have been more market-based reasons for the Apple flash crash. For example, investors could have been taking profits after Apple’s strong run over the fall. Alternatively, they could have been reacting to a recommendation by Morgan Stanley that its clients reduce their Apple stock holdings. The bottom line, however, is that no one is certain exactly what caused the Apple flash crash.

The more important question is this: What can be done to prevent future flash crashes affecting the entire market? The good news is that some regulatory changes were made after the 2010 Flash Crash that are designed to keep this from happening again. One of the biggest changes is the establishment of a maximum range in which a stock price can fluctuate during a short period of time.

This mechanism, which was established by the SEC, is known as “limit up-limit down.” It sets a price band at a percentage level above and below a stock’s average price during the preceding five minutes. If the stock price moves outside of this band — which is five percent for heavily traded stocks like those in the S&P 500 and ten percent for other stocks — within this timeframe, trading curbs will be automatically triggered.

Beyond this, some investor advocates are urging regulators to increase oversight of so-called “dark pools.” These anonymous trading entities are responsible for large volumes of trading activity in today’s markets. Advocates point out that Canada implemented regulatory restrictions on dark-pool trading in 2012. In response, Goldman Sachs has indicated that it might close one of its dark pools, Sigma X, to help solve the problem.

Is There Potential for More Flash Crashes?

Despite these regulatory changes, some market experts are concerned that the potential still exists for more damaging flash crashes like the one that occurred in 2010. Joe Saluzzi, the author of a book about how the stock markets are structured, has said he believes the markets are still susceptible to a flash crash of about seven percent, which would translate to a drop in the Dow Jones Industrial Average of more than 1,200 points.

For most investors, however, flash crashes are not something to worry about — especially if you have a long-term investing horizon. Flash crashes reflect intra-day fluctuations in stock prices, which should not concern long-term investors. History has shown that these wild price swings are mostly self-correcting, usually in a matter of minutes, if not hours.

If you are like most investors, you really should not be focused on minute-by-minute stock price fluctuations anyway. Instead, keep your focus on the long-term and your overall investing and portfolio management strategy.

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