Five Steps To A Flash Crash

How easy is it to cause a flash crash? Can it be accomplished by one trader working alone from the privacy of their home through a personally owned company account using commercially available software?

Five Simple Steps To A Flash Crash
Is it that easy to create a Flash Crash? It seems like there are five simple steps any trader can follow to initiate a flash crash.

Step 1: Buy a Computer
Step 2: Install Publicly Available Trading Software
Step 3: Connect to the Internet
Step 4: Fund Account
Step 5: Spoof The Market: Place and Cancel Orders FAST Using a Simple Algorithm

According to the latest allegations, this is all that is needed to cause a flash crash! Is it bad to submit and cancel orders fast, if the order is not filled? This appears to be the same steps taken by traders every day. If you cannot get the price, then you get out of the trade.

Spoofing, on the other hand, is intentionally placing an order without the intent to have that order filled and with the intent to create a fake view of supply in the market in order to manipulate price.

 To view larger image, click HERE.

On Tuesday, April 21, 2015, the United States filed a criminal charge relating to Navinder Singh Sarao’s role in the “flash crash” of 2010. On May 6, 2010, the Dow industrials sank by nearly 1,000 points before quickly recovering. Over the last five years there have been different ideas thrown around as to what caused the market to do what it did.

Flash Crashes Are Common & Double Standards Abound
Mini flash crashes happen all the time. There was a U.S. Dollar Flash Crash in March 2015 when the FOMC made a widely anticipated announcement. (See Nanex.) Besides news events, flash crashes can be caused by any number of things. It is best to be knowledgeable about the fact that they are real and be protected from the aftermath they may cause. For more information on flash crashes, click HERE.

A trader cannot place an order to manipulate the market. However, a fed head can rock the world with a move much larger than the flash crash causing margin calls and firms to shut down internationally. Read: Fed Interference Kills Traders

FXCM, the largest FX broker in the US, had to get rescued and bought out because of one international fed move that caused the brokerage to go negative. The move by the Swiss Fed could be seen as spoofing. They, themselves, said they were pegging the EUR/CHF price at 1.2000 and would continue to do so. They reaffirmed it that week before they pulled the rug from under the market. In a sense, they “verbally” placed orders to prop up the price showing a demand on the EUR/CHF, then cancelled the order causing a crash of massive proportions. More than electronic spoofing clearly needs to be addressed. To read more about what happened after the Swiss National Bank’s announcement in January 2015, click HERE.

Reality Check Time
If one trader from home with a simple spoofing algorithm can cause a flash crash of the magnitude saw on March 6, 2010, then how safe is any trader? To learn more about how to protect yourself from these kinds of occurrences see this article: How Not to Lose Your Pants...

Did Anyone Know The Flash Crash Was Coming?
A circuit breaker in trading is when the market is shut down momentarily if it moves a certain distance. There are certain breakers set for a variety of markets. You can see the limits for CME markets HERE.

The interesting thing about this particular crash is that the CME literally live changed the circuit breaks down before the full-throttle 10 point/handle jumps started happening. Click HERE to listen to TradersAudio with Ben Lichtenstein covering the S&P PIT Live Squawk Broadcast on May 6, 2010. Shortly into the recording you will hear him say, “That’s way too much!”, and “Sorry about that guys. There’s nothing I can do about that, guys.” He was saying these things as the circuit breaker levels were being changed which enabled the market to remain open before it crashed! They knew in advance! They also knew what level to move it to, meaning where the orders no longer existed. By moving the circuit breaker, the market was able to stay open and then pop back up making about a 50 percent retracement from the crash on the same day.

Over the next couple days, it fully regained the losses, and over the next few weeks it went back to below the low of the flash crash of May 6, 2010. In summary, the market went back up 50 percent the same day, regained 100 percent within a few days and then slowly retraced on back down. So the question is how did the exchange appear to know the crash was coming and then seemingly move the limit to below the low of the crash just before it happened? This is something to ponder upon.

Forexlive Report
When the flash crash happened, the emerging reports offered conflicting views. One source, Forexlive, dated October 13, 2010, said that the CFTC-SEC (Commodity Futures Trade Commission-Securities and Exchange Commission) Joint Advisory Committee on Emerging Regulatory Issues report “stated that deliberate attempts by traders to overwhelm exchanges with orders played no role in the May 6 crash. The majority of activity that occurred on May 6 wasn’t quote stuffing, it was quote withdrawals.”

What is quote stuffing? This is a technique used by high-frequency traders where they quickly enter and withdraw large orders causing their competitors to lose their competitive edge. Quote stuffing can often cause the trading systems to freeze up and confuse computerized trading programs. The report clearly stated that quote stuffing was not “the majority of activity…”

This report goes on to say that, “...the plunge was triggered by the sale of futures contracts on the Chicago Mercantile Exchange that set off a chain of selling that bled into stocks and exchange-traded funds. However, the evidence doesn’t support claims that delays triggered or otherwise caused the extreme volatility in security prices observed that day. The report further stated that NYSE was in the process of upgrading data systems on May 6. Less convincing are allegations about people intentionally trying to gum up the works without any evidence.” To read the full report, go to news.forexlive.com.

CFTC-SEC Report
The CFTC-SEC released its own 100-plus page report dated September 6, 2010, listing its detailed findings. On page 2, the analysis of what they feel happened is outlined. It begins by saying, “At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 EMini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.”

After some in-depth analysis, the report states, “...on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes.” See: Findings Regarding The Market Events Of May 6, 2010.

Since the Forexlive report quoted the CFTC-SEC and was released after, it seems the analyses have changed.

Five Years Later: More Conflicting Reports
Those facts may also be troubling for Navinder Singh Sarao, a Futures trader who was arrested in Britain on Tuesday, April 21, 2015, for his alleged involvement in the May 2010 flash crash. The U.S. says that he used an automated trading program to manipulate the market. He was able to place multiple, simultaneous, large-volume sell orders at different prices on the E-mini S&P 500. This is known as “layering.” Sarao created the appearance of substantial supply in the market. So with the new update was it order related or was it not?

Ratio Limits
If quote stuffing was not the issue, perhaps the problem occurred when ratio limits were exceeded. Ratio limits are the amount of messages in relation to the amount of fills for a given product. There is quite a bit that goes into the formulation of the ratio. To read more about how the CME Globex Messaging Efficiency Program (ratio limits) works, click HERE. Were there ratio limits in place before the flash crash? Yes, they were already there for the futures markets. To view ratio limits, click HERE. Ratio limits are still not on stocks.

If you do too many trades, you may receive a notification from the CME (Chicago Mercantile Exchange) telling you that you violated the ratio limits. The following is an example of the CME’s notification. Click HERE to view a larger image.

This explains that on the mini crude QM the ratio is 45:1. This trader had a ratio of 1047:1 and was subject to a surcharge of $2000 for every single contract traded at that firm that causes the ratio to exceed 45:1! There is already a program in place to deal with “spoofing” on futures and has been since before the flash crash. There were, and are, fines associated with doing it even before the flash crash. Since a program already existed before the flash crash, then did this trader exceed the ratio? If he did, did his broker not inform him that he exceeded it? Was he spoofing intentionally? Most traders have no clue what the ratio even is on submitting and cancelling contracts or what spoofing is or how it works, but there were already measurements in place pre flash crash for this to be identified.

Can You Place and Cancel Orders If Not Filled?
If your intent is to desire to get filled at a certain price and not manipulate the market then it is not odd to cancel an order immediately if not filled. Most traders are just trading alone in their own homes on their own computer using an algorithm that says “Buy to Enter,” “Sell To Exit,” etc. They are not trying to manipulate markets; they want their order filled. Most traders also want defined risk versus flash crash risk. If this is you, there better be some protection using defined risk instruments. There is an exchange where you can place and cancel orders instantly. Nadex allows you to submit, modify and cancel your orders nearly instantly, with limited risk. Nadex will be releasing the following types of “Limit Orders:”
To view a larger image, click HERE.

For more information, you can read this report about the upcoming changes happening at Nadex.

Whatever you decide about the validity of one trader being able to cause a flash crash is up to you, but since you are a trader, it is wise to be informed and protected in your trading. To access free education, visit www.apexinvesting.com, a service of Darrell Martin.