What is a Flash Crash?

A flash crash is an event in electronic securities markets wherein the withdrawal of stock orders rapidly amplifies price declines. The result appears to be a rapid sell-off of securities that can happen over a few minutes, resulting in dramatic declines.

Key Takeaways

  • A flash crash refers to rapid price declines in a market or a stock's price, due to a withdrawal of orders.
  • The biggest drop in DJIA's history occurred on May 6, 2010 after a flash crash wiped off trillions of dollars in equity.
  • High-frequency trading firms are said to be largely responsible for flash crashes in recent times.
  • Regulatory authorities in the U.S. have taken rapid steps, such as installing circuit breakers and banning direct access to exchanges, to prevent flash crashes.

A flash crash, like the one that occurred on May 6, 2010, is exacerbated as computer trading programs react to aberrations in the market, such as heavy selling in one or many securities, and automatically begin selling large volumes at an incredibly rapid pace to avoid losses.

Flash crashes can trigger circuit breakers at major stock exchanges like the NYSE, which halt trading until buy and sell orders can be matched up evenly and trading can resume in an orderly fashion.

Understanding Flash Crashes

Shortly after 2:30 p.m. EST on May 6, 2010, a flash crash began as the Dow Jones Industrial Average fell more than 1,000 points in 10 minutes, the biggest drop in history at that point. Over one trillion dollars in equity was evaporated, although the market regained 70% by the end of the day. Initial reports claiming that the crash was caused by a mistyped order proved to be erroneous, and the causes of the flash were attributed to Navinder Sarao, a futures trader in the London suburbs, who pled guilty for attempting to "spoof the market" by quickly buying and selling hundreds of E-Mini S&P Futures contracts through the Chicago Mercantile Exchange.

There have been other flash crash type events in recent history, wherein the volume of computer-generated orders outpaced the ability for the exchanges to maintain proper order flow: 

  • Aug. 22, 2013: Trading was halted at the Nasdaq for more than three hours when computers at the NYSE could not process pricing information from the Nasdaq.
  • May 18, 2012: Facebook's IPO—while not a flash crash per se, Facebook shares were held up for more than 30 minutes at the opening bell as a glitch prevented the Nasdaq from accurately pricing the shares, causing a reported $460 million in losses.

Preventing Flash Crashes

As securities trading has become a more heavily computerized industry driven by complicated algorithms across global networks, the propensity for glitches, errors, and even flash crashes has risen. That said, global exchanges like the New York Stock Exchange, Nasdaq, and the CME have put in place stronger security measures and mechanisms to prevent them and the staggering losses they can lead to.

For example, they have put in place market-wide circuit breakers that trigger a pause or a complete stop in trading activity. A decline of 7% or 13% in a market's index from its previous close halts trading activity for 15 minutes. A crash of more than 20% halts trading for the rest of the day. The SEC also banned naked access or direct connections to exchanges. High-frequency trading firms, who have been blamed for precipitating the flash crash's effects, often use their broker-dealer's code in order to access exchanges directly. Such measures cannot eliminate flash crashes altogether, but they have been able to mitigate the damages they can cause.