A Flash Crash Is Not Only Possible, But Likely

by: Paulo Santos

The convergence of a number of different data is driving me to think that a repeat of 2010's flash crash is not only possible, but likely. The coincidences and data are as follows:

NDX Sequence

The Nasdaq 100 (QQQ) index is now in its 14th up week in a row, helped by monetary stimulus (with the Fed implementing Operation Twist, and the ECB having provided the second 3-year LTRO at the end of February) and an improving economy. Back in 2010, the Nasdaq 100 index also went on a similar, albeit somewhat shorter, streak, as can be seen in the graph below (source: Stockcharts.com).

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click to enlarge charts

This kind of streak naturally increased complacency, leading to lower volatility as measured by the VIX (source: Stockcharts.com).

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Short interest

Short interest was going lower Tuesday as well, though it hit significantly lower levels prior to 2010's flash crash. A low short interest figure provides little buying support in case the market sells off (source: Nasdaq Short Interest Ratio, Bloomberg):

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Economic surprise index

The Citigroup Economic Surprise Index has already turned down, with the turn being clearer now than it was back in 2010. There's a correlation between this index and subsequent S&P500 (SPY) behavior, as can be seen in this article by The Disciplined Investor: "This Could Be A Reason Markets Are Getting Cranky" (can't reproduce the chart here). Visually, the correlation seems even better than the 0.22 one gets with the 3 month offset.

End of direct stimulus

Back in 2010, the Fed had just ended the QE1 stimulus program one month and 6 days earlier, before the market came unglued. Coincidentally, the ECB made its latest large monetary stimulus, the second 3-year LTRO, little more than one month ago (on the last day of February).

Wild speculation

Finally, there's one clue that seems to be getting larger in the windshield with each passing day. The speculative volume in short term Apple (AAPL) calls is completely out of control. I had already called the attention to it a few days ago when I commented on 208300 calls, the equivalent to 20.8 million shares, trading in the front month on a single day. But it's really going hyperbolic out there, with 569900 calls trading Monday, or the equivalent of 56.99 million shares, on a day the stock traded 29.8 million shares, already well above its 3 month average volume of 19.7 million shares. So it traded the equivalent of 191% of a single day's volume or 289% of the average 3 month volume in front month, short term, calls.

To have a feel of how unhinged this kind of trading is, Microsoft (MSFT) saw trading of 45163 calls, for an equivalent number of 4.5 million shares, on daily volume of 42.7 million shares and 3 month average volume of 52.5 million shares. So Microsoft traded the equivalent of just 10.5% of a single day's volume or 8.5% of the average 3 month volume in front month, short term, calls - a much, much lower number than Apple, underscoring the huge speculation now surrounding Apple stock.

Or another example, International Business Machines (IBM) saw trading of 10264 calls, for an equivalent 1 million shares, on daily volume of 4.1 million shares and 3 month volume of 4.4 million shares, thus having the options trading on short term front month calls corresponding to 24.3% of the shares traded daily and 22.7% of the average 3 month volume. The are still numbers far from Apple's, again underscoring the unique speculative moment Apple is undergoing.


The market isn't a bubble, and Apple certainly isn't a bubble either, yet many factors seem to be aligning themselves to produce the kind of behavior we saw back in 2010 - where the market wasn't a bubble either, with the market taking an instant hit on a very short time frame. The fact that there's unbridled and huge speculation in leveraged instruments (options) on the stock with the highest weight in the main indexes - Apple - reinforces this view.

Even though Apple is far from being a bubble in terms of valuation, this kind of market structure can clearly produce a 10-15% drop in a matter of days. If many of those traders speculating feverishly through options somehow decide to head for the exits, this would lead the delta-hedging activities of the market makers selling those options into a stock-selling frenzy.

What can unleash this kind of flash crash market behavior? Hard to say, even Monday's news on Sandisk (SNDK) could easily be mistaken for widespread tech weakness and lead to some selling that could feed on itself. Back in 2010, there was hardly one week between the market showing weakness and the market going straight down.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.