A flash crash is a quick drop and recovery in stock prices which is complete in a matter of minutes. The drop is usually slightly faster than the recovery. At the end of the flash crash, the stock market usually returns to around the same level where it was before the flash crash.
Causes of flash crashes
A flash crash can only occur in an automated trading environment. Only computers are fast enough to pick up on the initial error, adjust trades, and then adjust trades again when the error has been identified as an error, all within a matter of minutes.
The cause of a flash crash is always an unusual input. This can be an error in a trader’s manual input, an error in the information upon which the trade is based, or even a deliberately large trading condition. The flash crash ends when the error is caught, usually within minutes.
Whie millions or even billions of dollars may be involved in the flash crash, the vast majority of people who hold stocks will never notice it in any practical way. This is because most people do not trade stocks based on split-second timing. For these people, a minutes-long blip in the stock price will not matter.
Only people who do nearly all of their trading through high-frequency trading firms are likely to be affected in any major way. These people set up trading computer to identify key words in the news or social media and respond automatically with predefined trades. Thus, a false news story may trigger an automated sell-off, and the correction of that news storm just minutes later may trigger a parallel correction in the market.
The flash crash of April 23, 2013
At 1:07 pm, the Associated Press Twitter account tweeted shocking news: “Breaking: Two Explosions in the White House and Barack Obama is injured.” AP and Reuters are the 2 dominant news agencies in the U.S.
In near-instant reaction to the news, the Dow Jones Industrial Average immediately plunged. Within 2 minutes, it had dropped from a gain of 127 points into the red.
However, the news had been false. There had been no incident whatsoever. The AP Twitter account had been hacked.
As soon as AP found out, it suspended its Twitter feed and its reporters informed the public by way of their own Twitter accounts. The White House found out just as quickly. White House spokesman Jay Carney was on the air within minutes to dismiss the story. Most news sources only had time to write that the event had happened before the event was already over.
The flash crash of May 6, 2010
Before this flash crash, the Dow Jones had already been trending downwards over concerns about the debt crisis in Greece. At 2:41 pm, the Dow Jones was already down more than 300 points.
At 2:42, the Dow Jones suddenly plunged another 600 points over the next 5 minutes. The total loss was 998.5 points, roughly 9% of the total value of the Dow Jones, and the biggest 1-day point decline in history. Over the next few minutes, over $1 trillion in market value disappeared.
However, 20 minutes later, the market had reversed itself almost completely. By 3:07 pm, the Dow Jones was almost back to the original 300 point loss.
The official report found that in the uneasy economic climate of the time, a single, unusually large trade by a high-frequency trading firm had triggered a “hot-potato” effect which spilled over into the equities market. The unusual activity shut down the automated responses of other high-frequency trading firms, which froze liquidity across a wide range of stocks when suddenly no one was available to buy those stocks instantly.
In turn, the loss of liquidity caused traditionally stable stock prices to fluctuate wildly. The share prices of Accenture, CenterPoint Energy, and Exelon, all members of the S&P 500, all dropped to 1 cent per share. At the same time, the share prices of Sotheby’s, Hewlett-Packard, and Apple increased to over $100,000 per share.
This happened because when faced with a complete loss of demand, the automated trading computers used by the major companies of the Dow Jones automatically reverted to their preset stub quotes. These are extreme price parameters which are intended only as placeholder quotes in the abstract condition of complete loss of demand. They are never expected to be used in realistic trading. If a human being had had direct oversight over the trade, they never would have been used at all.
The spiral continued until 2:45:28, when trading on the E-Mini was paused automatically for 5 seconds by the Chicago Mercantile Exchange Stop Logic Functionality, which is an automatic market stabilizer. This pause was enough for buy-side interest to recover, which stabilized market prices.
The flash crash of May 6, 2010 is the largest flash crash to date. However, in today’s world of near-instant feedback and reaction, other, larger flash crashes may be yet to come.