Finance

The Flash Crash, Explained

The SEC just came out with a report that explains the "flash crash" — that very weird moment in May, when the stock market plunged wildly, then shot back up, all in the course of a few minutes.

Here's the gist:

A trader working for a mutual fund company (not named in the report, but identified in several news stories as Waddell & Reed) placed an order to sell more than 75,000 futures contracts whose value was tied to the S&P 500. The contracts were worth about $4.1 billion.

A trade that big typically takes several hours to complete, and requires many different buyers. It's common for firms to use a computer algorithm that determines exactly how to execute the trade.

In this case, the algorithm the firm used apparently failed to take into account one key variable: Price. (Yes, it sounds crazy. But apparently it hadn't been a problem up to this point.)

On this day, markets were already a bit wobbly. And as the sale of the futures contract progressed, the price began to fall sharply.

The falling price of the futures contracts then triggered other traders (or their computers) to begin selling actual stocks and stock funds. So the market started to plunge.

This steep fall in prices triggered many big traders (or their computers) to temporarily step out of the market, to assess the situation. Having fewer traders in the market only accelerated the price decline.

Thirteen minutes after the trader placed the initial sell order that triggered the decline, a market circuit-breaker paused trading in the futures contracts. The pause only lasted for five seconds, but it was long enough to break the cycle: When trading resumed, prices of both the futures contract and the stock market quickly recovered.

As the overall market shot back up to its earlier level, many traders remained on the sidelines. During those few minutes, there were some freakish trades, like $40 stocks selling for a penny a share. Regulators later undid those trades, calling them erroneous.

The SEC is testing out a few programs in response to the flash crash. One is to temporarily halt trading on individual stocks that rise or fall by 10 percent percent in five minutes. Another is to create clear rules for when trades will be deemed erroneous.

I checked in this afternoon with Robert Whitelaw, a finance professor at NYU's Stern School, who we talked to this spring, right after the flash crash happened.

In our conversation today, he argued that the report shows that there were in fact no "erroneous trades" during the flash crash. Those penny-a-share trades weren't the result of a glitch like a computer malfunction or someone hitting the wrong key. Instead, they were the result of people leaving in place orders that they thought would never be executed. (This is done to meet certain technical requirements.)

Adding new rules, Whitelaw argued, only adds to potential unintended consequences — and creates the illusion that the stock market is safe and predictable.

"One thing you would like people to know is stocks are risky and sometimes you can see big market moves," he said. "You want people to learn this stuff so they can use the market appropriately."

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