Looking Back on the Flash Crash, Nine Years Later

2010 Flash Crash

It’s the ninth anniversary of the infamous Flash Crash of May 6, 2010, and while this has been mostly forgotten these days, there are still lessons that we may learn from it.

Of all the events that have affected stock markets, there are perhaps none more interesting than the event known as the Flash Crash of 2010.

It’s not that the market fell all that much, and the movement during this time was only 5%, it was the sheer speed that all of this happened. When you drop 5% over a period of time, as we often do see, this really isn’t that remarkable, but when it happens in just a few minutes, that is another story entirely.

There were some observers that stated that, at the time, they were concerned that we wouldn’t make a recovery from this, with the flash crash having lasting effects beyond the few minutes of insanity that we saw. If we understand what is really happening here, it’s not hard to realize that these things are by their very nature temporary.

The Flash Crash gave us a glimpse of what pure momentum looks like, and the potential momentum of today’s stocks aren’t just limited to what human traders are capable of, for instance with the massive rise and fall of cryptocurrencies. We are now looking at how much momentum supercomputers can create, and it is indeed beholding.

This Happens Every Day on a Smaller Scale

The way things traded during this time of turmoil is not really much different from how things trade normally, although the sheer magnitude of the momentum that was created on that afternoon was simply massive.

This gives us great insight into the potential of algorithmic trading, which already dominates trading in general. Most of the trades these days are of this sort, computers themselves placing the trades, looking to use their speed to get ahead of things.

Most of this is what is called high-frequency trading, or HTF, involving computers taking positions for milliseconds. A lot of fingers got pointed at this sort of trading after the Flash Crash, even though it’s hard to imagine trades lasting fractions of a second sending anything plummeting or moving prices much at all.

The claim is that the unloading of positions in order to step aside caused the Flash Crash, but this unloading would have all occurred in microseconds, not the minutes that this all took to stop falling.

Make no mistake though, the Flash Crash was caused by computer trading, and a lot of this trading extends way beyond the microseconds of HFT. We’ve taught these computers trading rules, and then send them off to work. We’ve also allowed these programs to evolve, where the software is sent out to try various things and build on what works, so even the designers aren’t sure what is driving their decisions as the computers have taught themselves a lot.

Fingers have also been pointed at sources like a hedge fund who distributed over $4 billion of futures contracts during this time, or the trader who got convicted of spoofing, placing false bids and offers, which some believe caused the whole house of cards to fall.

When we look at the data though, it is clear that these orders for the $4 billon in e-mini futures did not affect the price very much, and almost all of it was from something else, something that would be well beyond the means of human traders to execute.

If you were holding a position and staying in the position involved managing risk, you will set it at a certain point, where you place an order to sell if it reaches this point. Human traders as well as computer ones use this, known as a stop order.

Your willingness to sell is also influenced by the price action, and seeing something decline will cause us to want to sell. When this is written in the code of your program, discretion is not part of the process and the machine will just act as ordered.

The fact that we saw such bizarre moves with some stocks, like Accenture dropping from over $40 a share to just a penny, really tells the tale here. No one in their right mind would sell this stock for a penny, or anything close to it, and would just wait this out. Computers lack this ability to reason this way though, or at least it would have to be programmed in.

It has been calculated that, during the time of the crisis, there was a 36 second delay in data transmission. When the market is falling as fast as it did, people sold when they saw too much, but so much more had already happened without their knowledge. This contributed to the instability as well.

For the same reasons as these programs sold off, once the momentum shifted, and it would have to very quickly, we rode things back up again. Some people complained that this cost them money by having their stops hit, but if this provided a lot of pain, and in some cases it did, this may serve to be a lesson to not set your stops so loosely.

Investors Shouldn’t Care About This, But Traders Should Be Excited About It

There is significant intraday momentum that is created by these computers trading that are of a lesser magnitude than the famous crash that they were involved in. Some criticize the presence of this form of trading, but its effects are short-term, and not the sort of thing investors should ever care about.

They especially do not want to be concerned about events such as the Flash Crash, where within minutes it was all over and we were back to where we were before all this happened. If you are holding at all then none of this affects you.

Traders, on the other hand, can become more challenged by the higher volatility that algorithmic trading provides, but the rewards are also greater. Those who engage in this practice do need to manage the risks properly, but this is central to good trading anyway.

We now have circuit breakers on both the market and individual stocks, which would have at least halted the plunge of stocks like Accenture and Procter and Gamble that we saw. The SEC did investigate the matter at great length, and know which institutions were responsible for this, but are prohibited from disclosing these findings.

We can assume though that this did involve several large institutional traders, as you can’t pull this off all by yourself. All of this was well within the rules though, and you can’t reprimand someone for exercising their rights to trade, even though some people may be looking for some actual names to point their fingers at.

We are left with the patsies of this story, the high frequency traders, the hedge fund, and the spoofing trader. The real culprit, if we can even call it that since none of this involves acts that are reproachable, is the new engine of the stock market, which is the trading of the big computers.

Flash crashes do stir up a lot of fear in people though, especially investors, and this does go against the goal of order and stability that is fundamental to the mission of financial exchanges.

By understanding that this is a blown up version of what we see every day in the markets, where a lot of the price movement that we see is caused by nothing else than algorithms playing the trend, this can serve to provide better insight as to the role of momentum itself in the movement of prices, and then look to take better advantage of it.

This can free us from the faulty assumptions that we often hold such as stock prices are determined by fundamentals which can leave us really shaking our heads when we get momentum runs.

The Flash Crash did provide us a glimpse of the power that these programs can unleash, and while it’s not really anything to be afraid of if you understand it, those who wish they traded the back end of this who might think that this opportunity may not come around again need to realize that this sort of thing happens every day in the markets, and isn’t that hard to spot either.

We saw some of this on Friday with the morning crash and the afternoon recovery, and you can bet that algorithmic trading was very well involved in both ends of this. Even the simplest of indicators fleshed this out very well and a lot of money was made by those with just the ability to spot very big intraday trends and capitalize both ways with this V shaped price chart that saw us go straight down 300 Dow points and then straight up for 500 more.

Investors will not care about these things so much but traders should be really paying attention here. A lot of traders mistakenly believe that algorithmic trading has made things more difficult, and while risk management may be more challenging, if you are a surfer, you should like the bigger waves that this trading brings, provided you really know how to surf.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.