The "flash-crash" of May 6: What happened?

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If you tuned in to stock market news at about 2:47 p.m. EST on May 6, you might have been holding your breath, especially if you have a significant investment in the stock market. That was five minutes into what is now being called a flash-crash, and at that moment you might’ve heard announcers in panic mode as the Dow Jones Industrial Average tumbled 990 points.

It had already been a bad day on Wall Street prior to that five-minute period. But, without warning, it suddenly looked like the bottom had fallen out of the stock market and we were on an unstoppable ride to the floor of the elevator shaft.

Then the market ticked up a bit, and in 90 seconds, it regained 543 points. To those on the trading floor it must’ve felt like Superman swooped out of the sky to prevent the final splat. By the closing bell, the market was still down 347.8 points, or 3.2 percent, but that was practically an oasis compared to the day’s low point – a 9.1 percent loss.

What happened?

There was a lot of speculation, including the fat finger theory, which suggests that someone intending to enter a transaction for millions of shares instead hit billions, sending the market into a whirl. An investigation was unable to determine a clear cause. But, the Securities and Exchange Commission and the various exchanges assigned to look into it believe that traders pulled back briefly, neither buying nor selling. Though they found no evidence of computer hacking or terrorist activity, they told reporters at The New York Times, “We cannot completely rule out these possibilities.”

Another theory suggested by some regulators is that brokers using an algorithm might have caused a blip in trading. Just before and just after the drop, one particular trader was exclusively entering large orders using an algorithm, which was intended to control that trader’s own impact on the market by limiting his or her volume to 9 percent of total volume. The trader denies responsibility, and some officials have told the press they don’t believe the use of an algorithm caused the crash.

Even though the market regained much of what was lost, many stock market regulars are not happy – with good reason. Those investors had stop-loss orders in place, which were intended to trigger an automatic sale if the associated stock fell to a preset price. The idea of course, is to mitigate loss. Unfortunately, having a stop-loss order doesn’t guarantee the price you specify if the market tumbles. On May 6, the market sailed right past many of those preset prices, triggering sales at the best possible price. In some cases, stocks sold for as little as a penny per share.

One investor lamented to The Wall Street Journal that he might have been over-thinking his portfolio. He set a stop loss at 20 percent below the latest high price of his stock, and updated it whenever there was a major upward move. The day before the flash-crash, he raised the stop-loss price from $46 to $49.17. The next day, when the market went into a freefall, his stop-loss kicked in. But, before his shares could sell, the price dropped to $41.15…and sold, which wiped out all the gains he had made in 18 months, he said. Before the market closed for the day, the price of the stocks which he no longer owned roared back, ending the day at $57.71.

Can another flash-crash be prevented?

Market forces can’t be controlled, but there are some protections already in place and, since May 6, some new ones have been devised. Currently, circuit breakers are set to halt trading under certain circumstances. If the Dow falls by 10 percent before 2 p.m. EST, a circuit breaker will halt trading for one hour. If the same decline occurs between 2 p.m. and 2:30 p.m., trading will halt for half an hour. After 2:30p.m., trading will only be halted if the market falls 20 percent. If that happens, the market will close for the day.

The May 6 crash began at 2:42 p.m. EST and peaked at 2:47 p.m. after a decline of 9.1 percent. That was enough to wreak havoc, but not enough for the existing circuit breakers to stop trading. Since the flash-crash, the SEC directed participants from the various exchanges to work together to develop a new set of parameters. After a 10-day comment period, the new parameters will be in place through December 10, 2010. According to the new parameters, if stock prices move 10 percent up or down within a five-minute period, the circuit breakers will kick in and trading will stop.

While the government has not been able to give a solid explanation for why the flash-crash happened, there are some details that illuminate what occurred in those dark minutes while Wall Street held its collective breath:

  • Not all stocks declined. Some small stocks shot up to more than 200 percent of their previous value before tumbling.
  • Of the stocks that ended up selling for pennies, more than 70 percent were involved in short-sell transactions.
  • Almost 200 stocks became nearly worthless, selling for a penny a share, before regaining some value.
  • 11,510 trades were made in those minutes, representing 3.5 million shares that sold for less than 10 percent of their value.
  • Shares that had pre-crash value of $212.4 million sold minutes later for $557,516.

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