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Flash Crashes

sudden plunge in the price of bonds, stocks, or commodities followed by a recovery

What are flash crashes?

Flash crashes are when the price of bonds, stocks, or commodities suddenly plunges but then recovers. It is called the flash as the market will crash suddenly but then the prices will rebound. At the end of the day, it would appear as though the crash has not occurred.

 

Flash Crashes Illustration - Lightening

 

Quick Summary Points

  • Flash crashes are when there is a sudden plunge in prices with stocks, commodities, and bonds followed by a recovery
  • Some causes of flash crashes include the use of algorithm trading which can increase volatility and decrease liquidity
  • It is difficult to pinpoint exactly what causes flash crashes

 

What causes flash crashes?

As mentioned above, flash crashes happen extremely quickly. So it is clear that the drop and rebound in price are not because of the release of bad news and then good news immediately after. Another point to consider is that the crash can impact the entire index, and not just one stock, bond, or commodity. The cause of the crash is not a change in the fundamental value of the stock but more so the because of the market structure.

To put simply, one cause of flash crashes are from computer programs or algorithms. Using algorithms to trade has become increasingly popular. These computers can take data and make trades within a second with large volumes, which is outside of human capabilities. Some algorithms are programmed to react to selling pressures. So as more sells are made compared to buys, the algorithms start selling too. This creates a snowball effect and at the speed in which computers make trades, a sudden plunge in the market occurs.

High-frequency traders is another factor that is believed to have caused or worsen flash crashes. These traders are the one that uses algorithms to perform large transactions at very high speeds. Traders can also purposely use algorithms to partake in illegal trades such as spoofing. With spoofing, algorithms are programmed to put in fake sales. For example, the traders will put in an order to sell 400 sales, but pull the order right before it is satisfied. By doing this, prices are driven down, which the traders will then buy.  With algorithms, this process has become too effective and is now illegal. This is just one-way algorithms can create volatility in markets.

 

More research needed

Based on the researches of the flash crashes that have happened, there are still a lot of unknowns concerning why these crashes occur. While high-frequency traders and the use of algorithms play a part in decreasing liquidity and promoting herd behaviour, it is expected that there are other factors at play. It is also hard to say whether there is a way for people or companies to purposely create flash crashes to earn a profit.

 

Examples of flash crashes

Flash crashes occur frequently. However, most are very small and does not make the news. The first notable flash crash was the 2010 Flash Crash. During this crash, the Dow Jones index lost almost 9% of its value and around $1 trillion in equity. However, the index was able to recover 70% throughout the day. This flash crash was especially significant for several reasons. Firstly, it was especially notable due to the large plunge in value and was reported by many news outlets. Secondly, it bought attention to the role that computer algorithms can play in creating market volatility and uncertainty.

 

2019 Yen and Australian dollar

At the beginning of 2019, the Yen increased 7% against the Australian dollar. The increase happened within minutes without any notice. This could have occurred due to a variety of reasons including lower than normal liquidity, and fear of global slowdown. On the morning of, Apple stated that their profits were down due to a slowdown in China. The news drove investors to buy yen, which is considered a safe haven currency.

 

Additional Resources

Thank you for reading CFI’s article on flash resources. To keep learning and advancing your career, we recommend these resources.

  • Noise Trader
  • Bargain Purchase
  • London Stock Exchange
  • Forex Trading

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