What Is a Flash Crash?
Recent Examples and What Caused Them
A flash crash is when a market, whether stocks, bonds, or commodities, plummets within minutes, and then rebounds. Different things can set it off, but the severity and speed of the crash is worsened by computer trading programs. These "bots" use algorithms that recognize aberrations, such as sell orders, and automatically react by selling their own holdings to avoid further losses. When a world event, or a computer glitch, tells these programs that something unusual is happening, they automatically sell (or buy) according to their code.
This makes any stock movement more intense, thus adding risk.
2015 NYSE Flash Crash
The floor of the New York Stock Exchange stopped trading for three hours and 38 minutes on July 8, 2015. Trading was quickly shifted to the eleven other exchanges, including the NASDAQ, BATS, and many "dark pools." The NYSE only accounts for 20% total trading, down from about 80% ten years ago. The cause of the shutdown is still being investigated. It's unknown whether it is linked to the closure of the Wall Street Journal's home page or the grounding of United Airlines' flights that occurred on the same day. (Source: "Glitch Freezes NYSE Trading for Hours," WSJ, July 8, 2015.
2014 Bond Flash Crash
On October 15, 2014, the yield on the 10-year Treasury note plunged from 2.0% to 1.873% within a few minutes, then quickly rebounded. That indicates a sudden surge in demand for these notes, since bond yields fall when prices rise.
This was its biggest one-day decline since 2009, and volume was double the norm.
What caused it? Many blame the high-frequency and algorithm trading responsible for nearly 15% of trading in U.S. Treasuries. This is part of the 60% of trading done electronically, instead of over-the-phone. That speeds up any reaction in the market.
In addition, there is limited liquidity in bonds available to sell. There were 54% fewer 10-year notes for sale than normal. For reasons why, see Bond Market Collapse: Causes and Effects. (Source: Tom Lauricella and Katy Burne, Bond Swings Draw Scrutiny, WSJ, November 9, 2014)
2010 Dow Flash Crash
On May 6, 2010, the Dow fell 1,000 points within 10 minutes, the biggest drop on record. It lost $1 trillion in equity, but by the end of the day it recovered 70% of the territory. The euro plunged to a one year low against the dollar. A flight to safety drove gold up to $1,200 an ounce and knocked the 10-year Treasury note yield down to 3.4%.
What triggered the sell-off? A London suburbanite, Navinder Sarao, sitting in his home using a personal computer. In 2015, investigators found that he made and quickly cancelled hundreds of "E-mini S&P" futures contracts, an illegal tactic known as “spoofing.” As a result, Waddell & Reed destroyed liquidity in the futures contracts by dumping $4.1 billion worth contracts.
The CME Group warned Mr. Sarao and his broker, MF Global, that his trades were supposed to be executed in good faith. Spoofing manipulates the market price by falsely building up the price, then quickly selling them for a profit.
(Source: Bradley Hope and Andrew Ackerman, Flash Crash Investigators Likely Missed Clues, WSJ, April 26, 2015.)
At the time, everyone thought the crash was caused by the Greece debt crisis. The county's debt had just been downgraded to junk bond status by ratings agencies, causing riots in the streets. If the ECB let Greece default, it could trigger defaults by other debt-laden countries like Portugal, Ireland and Spain. Investors who hold these countries' bonds will wind up with huge losses. Since many of these investors are banks, LIBOR rose - reminiscent of the 2007 bank credit crisis. This created fear of a credit freeze in European banks. (Source WSJ, A Glimpse Inside the "Flash Crash," June 10, 2012)
Like many other past crashes, it did not lead to a recession.
2013 And Other NASDAQ Flash Crashes
The NASDAQ is famous for flash crashes.
On August 22, 2013, the NASDAQ closed from 12:14 p.m. EDT to 3:25 p.m. EDT. One of the computer servers at the NYSE couldn't communicate with a NASDAQ server that fed it stock price data. Despite several attempts, the problem couldn't be resolved, and the stressed server at NASDAQ went down. (Source: WSJ, NASDAQ in Fresh Market Failure, August 22, 2013; Bloomberg, NASDAQ Three Hour Halt Highlights Vulnerability in Marker, August 26, 2013)
NASDAQ computer errors also caused $500 million in loses for traders when the Facebook initial stock offering (IPO) was launched. On May 18, 2012, the IPO was delayed for 30 minutes. In other words, traders could not place, change or cancel orders. Once the glitch was corrected, a record 460 million shares were traded. For more NASDAQ failures, see Computer Bugs and Squirrels: A History of NADAQ's Woes, August 22, 2013.
Is the Stock Market Rigged?
Michael Lewis, author of the recently released book "Flash Boys," said that the presence of these sophisticated high frequency trading programs means that the individual investor actually cannot get ahead. The programs can take in massive amounts of data, and made split-second decisions and trades long before a human can. Companies who use them, like Goldman Sachs and JP Morgan, haven't lost on a trade in years. For the average investor, says Lewis, the stock market is rigged.
On CNBC, Lewis defended his research to the CEO of BATS, the second largest exchange behind the NYSE. Like the NASDAQ, it's an all-electronic exchange, only larger. Billionaire investor Mark Cuban said the risk of a bigger flash crash is far worse than any "market rigged scalping."
How It Affects You
If Wall Street isn't rigged, it may as well be. There is no way an individual stock picker can collect more information or trade ahead of these computer trading programs. That's why so many asset classes are moving in tandem. These programs aren't regulated, either.
However, the situation is not hopeless. Although it's impossible to out-think these programs on a day-to-day basis, you can generally tell where the market is headed by following the business cycle. Keep a well-diversified portfolio, and adjust your asset allocation each quarter to make a decent return. Remember, it's not how much you make, but how little you lose. Article updated March 25, 2015
Stock Market FAQ
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- What Is a Stock Market Crash?
- Could a Stock Market Crash Cause a Recession?