Flash Crashes Are a Permanent Part of U.S. Markets: Should You Worry?

Flash Crash Chart of May 6, 2010

Flash Crash Chart of May 6, 2010

By Pam Martens and Russ Martens: July 10, 2017

Over the past year, there have been flash crashes in multiple markets, raising concerns that fat fingers, algorithms and/or rogue hedge fund traders are still running amok. We’ll get to the specifics in a moment, but to put the unusual trading patterns in context, you need some important background information.

Wall Street On Parade began reporting on flash crash activity following the Granddaddy of all flash crashes thus far – the event on May 6, 2010 when the stock market did a bungee jump, briefly plunging 998 points, with hundreds of stocks momentarily losing 60 per cent or more of their value and knocking out stop-loss orders for retail investors. Former SEC Chair Mary Schapiro estimated at the time that individual investors had lost more than $200 million in these improperly triggered stop loss orders on May 6. (Read our skepticism on the official regulatory report here.)

What is a stop-loss order? Small investors frequently put in place standing stop-loss orders that rest on the stock exchange order books to sell a stock at a pre-determined exit price that is lower than the current market in order to “stop” further losses. Once the target price of the stop-loss order is reached, the order automatically becomes a market order and is executed at where the market happens to be. In properly functioning, orderly markets, this would typically mean the stop-loss order would be executed at, or close to, the designated target price. In flash crash markets, on the other hand, it can result in massive losses to the little guy. (Read more granular details on these types of orders here.)

A stock market where stocks can lose 60 percent of their value in minutes, lock in losses for the little guy, then stage a miraculous recovery, is not really the kind of place where most people want to put their serious money. Indeed, the May 6, 2010 flash crash, following the revelations of abject corruption on Wall Street that emerged from the 2008 crash, permanently destroyed the confidence in U.S. markets for millions of Americans.

Given the outcry over the May 6, 2010 flash crash, one would have thought that Federal regulators would have gotten a solid grip on the situation to prevent another major flash crash. But just a little more than two years later, Bloomberg News was reporting the following about insane market disruption from Knight Capital:

“Between 9:30 a.m. and 10:00 a.m. EDT, one of Knight’s trading algorithms reportedly started pushing erratic trades through on nearly 150 different stocks, from Berkshire Hathaway to Nokia to Exelon. Trading volumes soared in many of them, so much so that the most traded stock on a typical day, the SPDR S&P 500 ETF, finished the Aug. 1 session as the 52nd-most traded stock, according to Eric Hunsader, CEO of market data service Nanex.

“…Knight’s buggy algorithm was apparently buying high and selling low, the opposite of a competent trading strategy…‘It totally freaked us out,’ Hunsader says. ‘If it hadn’t been stopped, it would have been a total disaster.’ He adds that the glitch led to 4 million extra trades in 550 million shares that would not have existed otherwise.”

Two years later the U.S. experienced a flash crash in Treasury yields. Nanex, reported that between 9:33 and 9:45 a.m. on the morning of October 15, 2014, “liquidity evaporated in Treasury futures and prices skyrocketed (causing yields to plummet). Five minutes later, prices returned to 9:33 [a.m.] levels.” Nanex goes on to say that “Trading activity was enormous, sending trade counts for the entire day to record highs — exceeding that of the Lehman collapse, the financial crisis and the August 2011 downgrade of U.S. debt.”

Less than one year after the Treasury debacle, on Monday, August 24, 2015, the Dow Jones Industrial Average plunged 1089 points within the first few minutes of trading. By the closing bell, the Dow was down just 588 points. Big cap stocks like JPMorgan Chase, Home Depot, GE, Apple, Ford Motor, Colgate-Palmolive, Merck and Verizon briefly plunged by as much as 15 to 20 percent.

There have been lots of other less notable events since 2010, including the events of the past year. Last Thursday, July 6, silver futures experienced a flash crash, plunging approximately 11 percent before bouncing back. On July 7, CNBC reported the following events which it has dubbed flash crashes:

“In other recent flash crashes, bitcoin rival ethereum crashed in New York afternoon trade on June 21 from near $317 to 10 cents on a major U.S.-based digital currency exchange called GDAX.

“On the evening of May 4, U.S. West Texas Intermediate crude futures fell more than 3 percent from $45.36 to a near six-month low of $43.76 a barrel in about 15 minutes.

“In early October, pound sterling lost a 10th of its value in a sudden decline that sent the currency to a 31-year low.”

The overarching question for Americans is why Congress and Federal regulators continue to wear blinders to the destruction of confidence in U.S. markets.

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