Much has been talked about the 'Flash Crash', a dramatic event that plunged the Dow Jones Industrial Average by over 900 points, and then recovered, in a short period of time. After a lot of investigation, the SEC produced a report on October 1, 2010. In the report, SEC attributed the event to a large E-Mini S&P Futures sales order by a single large investor, many believed to be Waddell and Reed Financial, Inc. (NYSE: WDR), which then unleashed a torrent of sales orders that quickly swamped the stock market.
While all attention is on the equity market regarding flash crashes, we witnessed a mini flash crash in USD/YEN forexland last friday (Feb 4, 2010). To give a perspective on why this is a flash crash event, one needs to know that Forex (Foreign Exchange) market is perhaps the largest trading market of all kind. In recent years, the average daily turnover of forex trading is estimated to be ~ $4 trillion. Even in this era where trillion is just another monetary unit, this is still a huge amount that dwarfs other capital markets. Of this, ~$1.5 trillion is in spot exchange, and Euro/Dollar comprises ~$420 billion, while Dollar/Yen comprises ~$210 billion. In short, the Forex market is a highly liquid market, with participants from all over the world ranging from central banks, major banks, mutual funds, hedge funds, retail brokers and investors.
On Feb 4, 2010 around 8:30am EST, when both New York and London markets are trading, perhaps it was a large buy order on yen, or perhaps a large related futures order, USD/YEN plunged from ~81.60 to ~81.30, i.e. > 30 pips in forex lingo, and then recovered, all within 1 single minute. This may not seem like much to an equity trader, but this is a huge swing in forex for such a short amount of time, considering that a lot of forex trading are done through leverage of 100:1. To further illustrate the disappearance of liquidity within that period, we had a small outstanding position with a stop order during that time, and it took a full second and three tranches (one lower than the order) for that stop order to be completed, whereas in a normal situation it may take ~1 micro second to complete the order in one shot.
For such a highly liquid market to experience a mini flash crash in such a short time frame, it makes people wonder what can really be done to prevent this from happening. While the SEC is taking different measures such as expanding circuit breakers, increase transparency of 'dark pool', etc., we are not sure how effective these measures will be to eradicate flash-crashes. There are also many markets out of jurisdiction of the SEC, which can and will affect the equity market in times of high uncertainty. In short, we believe flash-crashes, along with high frequency trading, are here to stay.
For an investor to protect himself against any flash crash, one must reconsider the use of stop orders. In the case of a flash crash, it's better not to have stop orders because it's going to bounce right back in a relatively short period of time. However, in the middle of a flash crash, it's extremely difficult to determine whether a flash crash is happening, or that a severe correction is under way. It is also against the trading rules of many people. An investor should therefore consider using tighter stops if they are worried about a flash crash. In the event of a flash crash, only a computer with proper monitoring of the action will have the chance to detect the pattern, and we believe such a service will come soon for portfolio managers and investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.