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Stock Market Coaching - Trading Glitches And Flash Crashes

Pop Quiz: Let's say you are trading a stock and suddenly, out of nowhere, a major exchange goes bonkers, perhaps is hacked by some foreign intruders. Consequently, the exchange data becomes corrupted and the market makers/specialists capriciously head for exits as fast as they can. Stop limit orders are being outrageously triggered and what's worse is the sell orders get executed 29.9% away from the last trade. However, the exchanges are able to locate the source of the network intrusion and fix it almost immediately (we know, slightly exaggerated, but just play along). The stock you were trading quickly recovers to what it was prior to the whole event. In addition to your trade there were over 500 other "bad trades" that were executed far from the reference price. Now the questions you would ask: What just happened? Exchange error? Does the exchange break your trade since it was "clearly erroneous"?

Before we answer those questions, let us tell you that such events are not completely hypothetical; these do exist in reality (or history). Most of us would be familiar with the quick-drop-and-recovery event on May 6, 2010, the cause of which is still unknown. More recently, on August 1 this year, the markets experienced another such occurrence where about 150 stocks traded with 20x their normal volume with many falling more 10% or more. To answer your questions, "No" the exchange would not do anything in that case. In September of 2010, after the infamous flash crash early that year, the SEC approved a little known FINRA rule request (Rule 11892), which created a new category for breaking of "clearly erroneous trades". And according to the rule should there be a "flash crash" type event, where there are over 20 securities with erroneous trades, only erroneous trades 30% or more will be broken. Since in your case you "just" lost 29.9%, the exchange would not break your trade. Further, it is not absurd to expect more of such events future, so it is important as trader to learn how to trade glitches and flash crashes, or at least, to know how to protect your trades from such adverse circumstances.

By the way, the event we are talking about here known as the 'flash crash', involves a steep drop and an almost equal rise in quick succession. They supposedly occur due to some technical glitches; however, no agency has been able to put a finger on its exact cause yet. And while its causes remains unknown, there will always be times when a company's stock flash crashes. Thereby making it even more important discusses a few trading techniques for it:

  1. Active Trading: Obviously, trading glitches and flash trades is not an easy task. Not only these events are extremely random but also are hard to identify. One should be an active trader to catch such moves, moreover should have the ability to identify random glitches in markets and act swiftly before the price recovers. Access to and understanding of as many technical indicators and their implausible extremes would certainly give you an edge over the other traders. Depending on news feed for confirmation could be counterproductive, as flash trades would be over by the time it is on the news.
  1. Always Use Limit Orders: This is a precautionary measure as well as trading technique that would reduce your risks during flash crashes. It is advised to never use market orders during such uncertain times, as the market makers can easily take advantage of you and fill your order at the worst possible price of the day - depending on whether you are selling or buying. Could you imagine prices you would get if you were to sell a market order to exit of a trade (or simply initiate a short sell)in a stock on the day of the flash crash? The market orders can significantly add on to your losses - for exit position - or eat out a major chunk of your profits for short trades. This also applies to stop loss orders, where you should always use stop limit orders to avoid falling prey to the 30% or more drop - FINRA rule as illustrated in the example earlier.
  1. Buy Companies with Good Fundamentals: This is a technique if you are unsure of the sudden down move, and perhaps cannot immediately identify a glitch or anticipate a flash crash. In such cases, to reap benefits from the falling prices it is always better to quickly invest in companies that have good fundamentals. So even if the prices do not move back to their original levels, as it should ideally in the case of a flash crash, you would still be holding a fundamentally strong stock at fairly discounted prices.
  1. Diversify: In times of such high volume trades, emotions run high among the traders. And though a glitch and a subsequent flash crash can occur in a handful of securities, but its effects will be felt in most stocks, at least to a certain extent. Over the uncertainty of recovery and lack of time to research, it would be better to diversify your investment when the prices are falling. This way you increase your chances of participating in recovery-leg on the flash crash.

It can be seen that the markets are showing enormous interest in researching about these little known random events and as the mystery around flash trades will slowly unfold, there will number of techniques to trade such events in future. As of now, these four techniques/measures should assist you in handling and perhaps profiting from the curve ball known as the flash crash.