What are flash crashes? Price drops out of the blue!

Flash Crash: Definition and Causes

A flash crash is a sudden and drastic drop in the price of stocks, commodities or other financial instruments, followed by an equally rapid recovery. As a rule, this “spectacle” is over within minutes or even seconds. Flash crashes are therefore characterized by their speed and the extreme volatility they trigger on the market.

The causes of flash crashes can be varied. Possible reasons include technical problems, high-frequency trading, human error or price manipulation.

• Technical issues:

Today, global stock exchange trading is based much more heavily on electronic trading computers than in the past. These carry out purchases and sales automatically based on specific rules (algorithms). The increasingly important role of computers in trading is one of the main causes of flash crashes. For example, so-called Software glitches sometimes for the fact that average market data is not effectively exchanged between stock exchanges, which is why inaccurate prices are transferred to a security. Incorrectly shutting down or booting up the systems can also lead to a flash crash. This was, for example, in January 2023 on Wall Street the case.

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• High-frequency trading:

Before the historic first flash crash in 2010, stock market thunderstorms were a relatively unknown phenomenon, as they only occurred with the introduction of high-frequency trading. Automated trading and its algorithms can trigger a domino effect. Computers react immediately to initial deviations in the market by automatically selling large quantities of securities. This in turn pushes prices down even lower and triggers further algorithms as the market value falls. Interestingly enough, the same trading systems are also decisive for subsequent consolidation. Because, of course, there are also algorithms that trigger a purchase as soon as the price of a security has fallen below a certain level. As soon as these algorithms trigger the purchase order for a financial product, the balance is restored relatively quickly.

• Price manipulations:

With the now illegal Spoofing Thanks to algorithms and high-frequency trading, stock market traders were able to manipulate stock prices to their own advantage by placing a high order but withdrawing it automatically and in a flash. The spoofers were then able to sell or buy a manipulated value in their favor before the price correction began. Price manipulation of this kind, for example, triggered the first flash crash in 2010.

How often do flash crashes occur?

The Flash Crash phenomenon was first mentioned in 2010, when the Dow Jones fell by more than 1000 points within a very short period of time on May 6 — the biggest share price loss in one day in the index to date. Within ten minutes, almost 1.3 billion securities were traded in stock trading, which was approximately six times the average trading volume. Many stocks lost a large part of their original price value within seconds; some as much as 99 percent. It is estimated that this flash crash destroyed a trillion US dollars for a short time. It wasn't until years later that investigators discovered that an individual trader from London had triggered this flash crash with computer-aided price manipulation through spoofing.

At around 01:00 CEST on October 7, 2016, after months of Brexit negotiations on the Asian foreign exchange markets, there was a sudden drop in the British pound. Within a few minutes, the pound fell by up to ten percent against the US dollar. It recovered shortly after, but was still down by around 1.5 percent.

Another flash crash followed on Wall Street in February 2023. The difference with 2010, however, was that it was not the overall index but many individual stocks that were affected. These include in particular heavyweights such as Walmart or Wells Fargo, which have since lost value by two digits. The cause of this flash crash was human error. Because the backup system in Chicago was not shut down and restarted as usual after the end of trading, but continued to run overnight, the exchange's computers treated the 9:30 a.m. opening as a simple continuation of trading on Wall Street. They skipped the opening auction, which normally set the regular opening prices, and triggered orders at all possible prices.

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How should investors react to flash crashes?

Flash crashes are worrying because they disrupt market stability, undermine investor confidence, and reveal the weaknesses of highly connected and automated trading systems. Regulatory authorities and market participants have therefore now taken measures to reduce the risk of flash crashes.

As a result of the first flash crash in 2010, for example, the US supervisory authority Securities and Exchange Commission (SEC) implemented so-called Circuit Breaker, which automatically interrupt trading in the event of large price movements. For smaller stocks, there is a price loss of ten percent, for larger stocks there is a price slide of three percent.

For long-term private investors who do not allow themselves to be carried away by temporary events into ill-considered sales, flash crashes are actually irrelevant, as the losses are compensated relatively quickly. For day traders, on the other hand, lightning crashes can involve high risks, but also opportunities for bargains. Automatic protection mechanisms such as a stop loss order, in which a sell order is executed at a pre-defined price in order to limit losses, can also be adversely affected in the event of a flash crash. For example, when it triggers the stop loss order even though the price rises again a few minutes later.

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