Flash Crash

October 4, 2010 by Guest Contribution

(Guest Contribution by Abdulla Al Khamis)

What really happened to the market on May 6, 2010? The Dow Jones Industrial Average lost almost  1000 points by 2:47p.m.

It took the SEC five months to pinpoint the reasoning for the cause of the so-called “flash crash.” Reporters identified Waddell & Reed Financial Inc. as a main contributor due to the high frequency trades set by the mutual fund company.  The firm used a trading algorithm program to executed 75,000 E-mini futures contracts valued at more than $4 billion. E-mini Index future contracts are miniature versions of the same futures contracts that are based on the major market averages and indexes, but can be traded for a fraction of the margin of the larger contract.

It all started at 2:32 pm when the firm placed the order to sell 75,000 E mini futures contracts that mimic the S&P 500 index. Within seconds, High-frequency trading firms and other investors started participating in the trade and buying those contracts, only to start selling them aggressively within 9 minutes, at 2:41 pm.

High-frequency trading firms started buying and selling these contracts to each other in a matter of seconds, thus creating a so-called “hot potato” effect. Some 27,000 contracts were traded in less than 14 seconds, bringing down the price of E-mini contract by 3% in 4 minutes. The selloff in the futures market caused an effect in the market for individual stocks, causing the liquidity in the market to dry up because of the pause of the automated systems when prices fell significantly.

What would happen if such “flash crashes” went on more often? Would it still take the SEC five months to pinpoint the causes of twenty minutes of trading?

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6 Responses to “Flash Crash”

  1. Sal says:

    Great post! Keep it up ;)

    [Reply]

  2. Bo6air says:

    this is the kind of risk that no talks about in schools or the CFA! even though something similar happened in ‘87!!!

    Financially and psychologically you must be prepared for such risks. And never think that the SEC or any other regulator will come out with a solution.

    [Reply]

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