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What Caused the Flash Crash? Most Important Will it Happen Again?

By on Mar 19, 2013 in Personal Investing | 0 comments

Article by, Brent Virkus www.tritoncapitaladvisory.com

Prior to founding TRiTON Capital Advisory, I spent a number of years on Wall Street managing individual investment portfolios. Find the Capital.com asked me to write a short article on what may have caused the Flash Crash and whether it can happen again. So here we go…

In what is now being called the “flash crash”, the Dow lost over 700 points in a matter of minutes, at one point being down nearly 1,000 points for the day, before storming back.  I actually watched Apple’s stock go from $258 per share to $199 per share in just a few minutes!  The worst part about this was I tried to buy it at $200 but there was so much volume the system would not take my trade…  The stock is now back up over $250 per share!  That day was complete madness and really should beg the question:  Is the market broken?

In the wake of that craziness, exchanges and investors have had to sift through broken trades and regulators are still trying to figure out what happened.

The Find the Capital.com’s followers keep asking me the same questions.  What caused the flash crash?  Was it just a mistake?  Was it a glitch in the system?  Was it a terrorists attach?  And the biggest question of all:  Should I be worried about it happening again?  This question I can answer with no uncertainty.  The answer is YES!  It will happen again…

Searching for the same answers, We’ve scoured our contacts throughout the industry.  Only one answered the question honestly.  A 50-year veteran in the stockbrokerage industry and his answer was simple.  “I have absolutely no idea…”

As an active trader for over 20 years and over 15 years in the business as a stockbroker, I’ve learned a lot about what really happens behind the scenes.  In this newsletter, blog, whatever you want to call it, I’m going to give you our read on what happened.  I hope it helps bring some clarity to a very confusing situation.

Some of the Biggest Theories

Before talking about what may have happened, let us begin with some of the exciting theories that have been roundly discarded by the experts.

The Fat Finger:

This describes a trade where a human input error leads to a significantly erroneous trade, like adding an extra “zero” to an order. In this case, there was a rumor that a trader mistakenly input a sell order for either S&P 500 futures or Procter & Gamble (NYSE:  PG) stock as “billion” instead of “million”. It is an amusing idea, but there are fail-safes at trading houses and exchanges that would flag such a mistake.  In my opinion this is definitely not what caused it.  I think the people behind the scenes were looking for a simple answer to calm the ensuing panic amongst investors.

Rogue Traders and Terrorists:

There have been many stories claiming that a certain investors sold a large amount of futures or bought a large amount of puts just before the crash began. Likewise, others have whispered that it was a cyber attack by the likes of Al-Qaeda or the Chinese. In all cases, regulators and investigators have found no evidence to support these ideas and if it were due to the actions of a single U.S. money manager, we would know by now.  In my opinion, it may have not been the case this time, but terrorist activity is certainly something to be concerned about.  To find out how to take cover, read Terrorism’s Effects On Wall Street.

What May Have Really Happened?

I consider it a near-certainty that there was no single cause of this flash crash.  More likely, it was a collection of events that happened to just all go wrong at the same time.

One detail that is important to understand is just prior to the drop in the stock market, there was a drop in the S&P emini futures.  These are futures contracts traded on the Chicago Mercantile Exchange and are hugely popular with traders, and the daily dollar volume is often much higher than that of the actual stocks in the S&P 500.  These contracts matter because of arbitrage – the price of the S&P futures and underlying stocks are linked and will move together.

Sudden Liquidity Drain:

Generally speaking, there are about a half-dozen firms that provide about half of the liquidity in the e-mini futures. That is a huge amount of volume in the hands of a small cadre of traders. It appears, though, that as selling began on that fateful day some of these traders left the market. As we have seen in every financial market (whether stocks, bonds, options, or futures), a sudden drop in liquidity can be very bad for prices and morale and prices can fall precipitously.

Stub Quotes:

Have you ever looked up a quote for a stock outside of market orders and seen a bizarre bid-ask spread like “Bid – 0.01 Ask – $100,000”?  That is a stub quote.  Market makers are required to maintain active bid and ask prices for their stocks, and those prices are supposed to be legitimate.

In practice, though, sometimes market makers do not want to trade and that is when they will offer those ridiculous spreads. There is never any intent to actually do business at those prices, but they are real offers and when computerized systems cannot find a better place to execute a trade, those stubs will get hit. That, in a nutshell, is how we saw some stocks trade for one cent on the day of the flash crash.

Mismatched Trading Rules:

Unfortunately, the various stock exchanges open to investors and traders do not have a uniform set of rules. The simplest example is the NYSE, which still uses a mix of electronic and human trading. In periods of exceptional chaos or volatility, these mismatches in rules can cause big disruptions in order flow and liquidity, sometimes moving trades away from markets with willing traders and credible quotes and into the periphery where issues like stub quotes become relevant.

Intermarket Sweep Orders:

This is a relatively unusual type of stock order that is almost never used by regular investors.  Typically, investor orders are routed to whatever market offers the best price – many NYSE-listed stocks are actually traded through Nasdaq or electronic exchanges.  Some investors, especially those engaged in algorithmic trading, will use a sweep order to direct trades to a specific market regardless of price. That can lead to trades being executed at very strange prices if there is a failure in liquidity in the markets. In the flash crash there were many strange quotes for NYSE-listed stocks trading on Nasdaq.

Stop-Loss Orders:

Stop-loss orders are often promoted as a way of reducing risk, but they can actually amplify a crisis under certain conditions. Stop loss orders become active when a stock declines to a certain level and create automatic sell orders. If a stock or index is dropping rapidly, an influx of sell orders can function like throwing gasoline on a fire. It is entirely possible, then, that the triggering of thousands of stop loss orders led to a flood of sell orders and an extreme amount of downward pressure on prices for a short period of time.

Arbitrage:

Along similar lines, the linkage between futures and stocks cannot be ignored. Arbitrage is a well-known and reputable part of a healthy and functioning market, but it can lead to strange results in volatile times. As the S&P futures dropped, it triggered automated orders to sell the underlying stocks, which triggered a vicious cycle as the selling in futures led to selling in stocks, which led to more selling in futures.

Our advice

Unfortunately, systematic breakdowns are an inevitable weakness of any elaborate system. In other words, despite the best intentions of the SEC, exchanges and brokerages, something like this will happen again eventually.

The best thing an individual investor can do is educate yourself.  You need to take control of your investments.  Trust no one.  There are no magic answers.  Develop a strategy and stick to it.  There are a lot of tools available to the individual investor that I never had as a broker.

The most important thing I can tell you is the “buy and hold” strategy that all the experts preach no longer works.  In fact it has never worked and the strategy is outright dangerous!

Once you enter a stock, manage your position.  This is the most important thing you can do.  Always cut your losses at 7% – 8%.  Don’t let bad decisions get out of control.  If you are not able to watch the market every minute of the day, make sure to use stop-limit orders not stop loss orders.  A stop loss order means that once a trigger price is reached, an order is issued to sell that stock as soon as possible, at whatever price.  This is how most people get burned.  In my Apple example in the beginning of the article, the stock dropped from $258 to $199 in just a few minutes.  If you had a stop loss order in for $240 per share, you might have actually sold at $199.  My assumption is you might not have been as interested in selling at $199 as you were at $240… A lot of investors got burned this way during the flash crash.

A stop-limit order, however, is likewise triggered by a decline in the stock price but the order specifies a price below which the trade is canceled.  In the Apple example, that would have caused the trade to not execute.

It is imperative you learn and understand proper portfolio management.  Trust me, the pros do.  You should also!

Anyway you look at it.  There is no doubt.  This is going to happen again.  Make sure you keep your “eye on the ball”.

 

Professor“It’s Official…The Stock Market is at an All Time High. Yup it’s never been higher!”

So how does the every day investor protect themselves? Check out this FREE Video on Timing the Market Just Like the Pros! Protect what you’ve made…

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