Flash Crash: Full Story Finally Revealed

Last Updated Oct 4, 2010 11:14 AM EDT

This article was updated on October 1, 2010
Blame it on Kansas. Federal regulators have concluded that a single trade touched off the the May 6 'flash crash' that saw the Dow plunge 700 points in just a few minutes before quickly recovering. In a report released last week, the SEC and the Commodities Futures Trading Commission say that the sale of more than $4 billion in futures contracts, which normally would have executed over many hours, took place in just 20 minutes, triggering the tornado of selling. While the government does not identify the seller, press reports name Waddell & Reed, the Kansas-based mutual fund company.

Just a few days after it happened, SEC chairman Mary Schapiro said that "the technologies used for market oversight and surveillance have not kept pace with the technology and trading patterns of the rapidly evolving and expanding securities markets." That's a fairly scary admission. The whipsawing spooked investors and there's concern that it has contributed to their reluctance to put money into the stock market since that time.

Schapiro, who would obviously like to restore investors' confidence, says that the SEC has plans for preventing a re-occurrence of such swings. But even if Schapiro and the SEC can prevent a repeat of the specific problems that led to this incident, the markets and new technology will undoubtedly surprise us with some other glitch in the future.

As the Wall Street Journal reports, one of the primary causes of the flash crash seems to have been improvements in trading speed and execution in recent years that were intended to improve liquidity and lower costs. But those changes helped the big players who execute algorithm-driven trades in milliseconds, not individual investors. In fact, by jumping in front of the rest of us, the high-frequency traders drive up prices. In short, the ability to do ultra-fast trades anywhere and everywhere is not necessarily a good thing for the markets. Barry Ritholtz over at The Big Picture has a good rundown of recent regulatory changes that may have led to the flash crash.

One important lesson from the flash crash was the danger of stop loss orders when the market goes haywire. Normally, if you have a standing order to sell shares when they drop, say, 10 percent, and your $20 stock starts tanking, the order will be filled around $18. But when the market bursts downward at the speed of high-frequency trading, you might not get a bid at $18; instead it might be much lower. So you end up selling at $15, and then the market recovers and the stock is back at $19.50. Instead, you can use stop limit orders, which specify the exact price level at which an order will be executed. Or you can just avoid using stops altogether. Also, be cautious about your use of exchange-traded funds, which had the largest percentage of canceled trades on May 6.

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