A flash crash is when the value of a market plummets in electronic trading over a short period of time. It underscores the volatility that comes along with trading, especially in the digital age.
Learn more about flash crashes and the actions that have been taken to prevent them.
Definition and Examples of a Flash Crash
A flash crash occurs when the value of a market drops significantly in electronic trading over a short time period. The original flash crash occurred on May 6, 2010, when the Dow Jones Industrial Average dropped almost 1,000 points within 10 minutes. The plunge cost $1 trillion in equity.
It recovered most of its lost territory by the end of the day. The euro plunged to a one-year low against the dollar. A flight to safety drove gold up to $1,200 an ounce. It knocked the 10-year Treasury note yield down to 3.4%.
The opposite of a flash crash—a rapid increase of prices in a market—is sometimes called a flash spike.
How Does a Flash Crash Work?
An extremely large block of trades can usually set off a flash crash. Computer trading programs make any crash worse. These "bots" use algorithms that recognize aberrations, such as sell orders. They automatically react by selling their holdings to avoid further losses.
These programs automatically sell according to their code when a world event or a computer glitch tells them that something unusual is happening. These trading programs make any stock movement more intense, adding risk.
The concern is that one of these crashes could could cause a recession. A typical stock market crash signals a loss of confidence in the economy. When confidence is not restored, it leads to a recession. Investors usually realize a flash crash is caused by a technical glitch, not a loss of confidence.
But a flash crash could trigger confidence loss if it lasted long enough to cause concern. It would also destroy wealth for investors. It might even frighten consumers into buying less if it lasted long enough. It could be just enough to trigger a recession at the wrong phase in the business cycle.
Mini flash crashes—quick drops in the prices of individual securities or futures—occur regularly.
Past Flash Crashes
Several flash crashes have occurred in the millennium.
2015 NYSE Flash Crash
The floor of the New York Stock Exchange (NYSE) stopped trading for three hours and 38 minutes on July 8, 2015. Trading was quickly shifted to the 11 other exchanges, including the NASDAQ, BATS, and many "dark pools." The NYSE lost 40% of trading volume as a result.
The cause of the shutdown is still unknown. It could have been linked to the closure of the Wall Street Journal's homepage, or the grounding of United Airlines flights. Both occurred on the same day.
2014 Bond Flash Crash
The yield on the 10-year Treasury note plunged from 2.02% to 1.86% within a few minutes on Oct. 15, 2014. It quickly rebounded. The plunge made it seem like a sudden surge in demand for these notes. Bond yields fall when prices rise. It was the biggest one-day decline since 2009. Volume was double the norm.
Many blame the algorithm-based programs that are responsible for most of the trading in the U.S. Treasury, with estimates of 50% in cash securities and 60% to 70% in futures. An increase in electronic trading has reduced the bank's involvement and over-the-phone orders. The combination of automation and high frequency trading can speed up any reaction in the market.
There was also limited liquidity in bonds available to sell. The market depth was unexpectedly low, even though the volume in the 10-year note was up.
2010 Dow Flash Crash
The Dow fell 1,000 points within 10 minutes on May 6, 2010. It was the biggest point drop on record, costing $1 trillion in equity.
A London suburbanite, Navinder Sarao, was sitting in his home using a personal computer at the time. Investigators found five years later, in 2015, that Sarao had made and quickly canceled hundreds of "E-mini S&P" futures contracts. He engaged in an illegal tactic known as “spoofing.” Waddell & Reed destroyed liquidity in the futures contracts as a result by dumping $4.1 billion worth of contracts.
The CME Group warned 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.
Everyone thought at the time that the crash was caused by the Greek debt crisis. The county's debt had just been downgraded to junk bond status by rating agencies. This created protests in the streets. It could trigger defaults by other debt-laden countries like Portugal, Ireland, and Spain if the European Central Bank (ECB) let Greece default. Investors who held these countries' bonds would have incurred huge losses.
Many of these investors were banks, so the London Inter-Bank Offered Rate (LIBOR) rose. This was similar to what happened during the 2007 bank credit crisis. It created fear of a credit freeze in European banks.
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. It closed from 12:14 p.m. to 3:25 p.m. EDT on Aug. 22, 2013. 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.
NASDAQ computer errors also caused $500 million in losses for traders when the Facebook (now Meta) initial public stock offering was launched. The IPO was delayed for 30 minutes on May 18, 2012. Traders could not place, change, or cancel orders. A record 565 million shares were traded when the glitch was corrected.
Is the Stock Market Rigged?
Michael Lewis, author of Flash Boys, said that the presence of these high frequency trading programs means that an individual investor cannot get ahead. The programs take in massive amounts of data and make split second decisions and trades long before a human can do so. Companies that use them, such as Goldman Sachs and JP Morgan, haven't lost on a trade in years. The stock market is rigged for the average investor, says Lewis.
Lewis defended his research to the CEO of BATS, the second largest exchange behind the NYSE, on CNBC. It's an all-electronic exchange like the NASDAQ, but larger.
How It All Affects You
If Wall Street isn't rigged, it may as well be as far as you're concerned. There's no way an individual stock picker can collect more information than these computer trading programs. That's why so many asset classes move in tandem. These programs aren't regulated, either.
But the situation isn't hopeless. It's impossible to outthink these programs on a day-to-day basis, but you can tell where the market is headed by following the business cycle. Keep a well-diversified portfolio. Adjust your asset allocation each quarter to make a decent return. Remember, it's not how much you make, but how little you lose.
- A flash crash is when the value of a market plummets in a short period of time due to electronic, automated trading.
- Flash crashes are usually caused by an extremely large block of trades, along with the automatic reactions of computer trading programs.
- The original flash crash occurred in 2010, and there have been several others since then.
- A flash crash generally doesn't cause a recession, but it could be enough to trigger one if the crash occurred at the wrong phase in the business cycle.