What is a Flash Crash?

Published by Thomas Herold in Economics, Investments, Trading

'Flash Crash' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

The Flash Crash has also been called the 2010 Flash Crash and the Crash of 2:45. It occurred on May 6 in 2010. This stock market collapse occurred in the United States and caused a trillion dollars of equity to be temporarily wiped out. It began officially at 2:32 EST. The crash happened over only the next 36 minutes.

During this crash, major stock indices including the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite fell apart and then rebounded with unparalleled speed and volatility. At one moment, the DJIA set its largest point drop within a single day to that time. It fell 998.5 points representing over 9% of its value.

Most of this drop happened in only minutes. The index then went on to recover a substantial portion of the drop a little later. Up to this point, this represented the second biggest point swing in a single day at 1010 points.

Trading volume exploded briefly as volatility increased. The prices of stock indices, individual stocks, futures on the indices, options, and ETF exchange traded funds were all over the board. In 2014, the CFTC Commodities Futures Trading Commission released a report that called this just over thirty minute crash among the most chaotic points in all of the history of global financial markets.

The government responded by putting a number of new regulations into play after the 2010 Flash Crash. Despite this fact, they were insufficient to stop another such rapid crash on August 24, 2015. During this second episode, bids on literally dozens of stocks and ETFs plunged to as little as a single penny per share as ETFs decoupled from their underlying value, per the Wall Street Journal article of December 6, 2015. As a result of this second incident, regulators placed ETFs under additional scrutiny. This also led to the analysts at Morningstar stating that legislation from the Depression era was governing the digital age technology of ETFs.

It took the Department of Justice almost five years to charge an individual with criminal misconduct that contributed massively to the original flash crash. They charged the trader Navinder Singh Sarao with 22 counts of market manipulation and fraud. Apparently he had utilized spoofing algorithms to trick the exchanges.

Immediately before the crash unfolded, Sarao had put in orders for thousands of the stock index futures contracts known as E-mini S&P 500 contracts. These orders constituted $200 million in bets that the markets would then decline. Before the orders were cancelled by his algorithm, it modified or replaced them 19,000 times. Thanks to this individual action, the government and regulators banned front running, layering, and the spoofing of orders.

In the investigation that the CFTC conducted, they came to the conclusion that Sarao bore substantial responsibility for the imbalances of the orders in derivatives markets. These impacted the stock markets and made the crash so much more severe. The small time trader Sarao was operating from his parent’s house in the suburban part of west London when he carried out these actions. He had started manipulating the markets back in 2009 when he purchased and modified trading software that would permit him to quickly and automatically place and cancel his orders.

A later CFTC report in May 2014 determined that the high frequency traders who were assigned much of the blame for the flash crash did not cause it themselves. They did contribute to the severity of it as their orders were taken before those of other participants in the market.

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The term 'Flash Crash' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.