HedgeFundLIVE.com – The Flash Crash (FC), May 6th 2010, is the biggest one-day point drop in the history of the DJIA (998.5 points) and the third highest volume day ever (but one of the most illiquid). Studies conducted by the SEC and other private groups have shown the FC was caused by a multitude of factors, which can be understood simply as a snowball effect.
Factors, such as liquidity consumption, high-frequency trading, normal market action, and a lack of retail trading all played into the historic move. Contrary to popular believe the FC was not caused by a “fat finger” or one single High-Frequency Trading firm (HFT). This article will attempt to clarify the confusion, discuss the use of the VIX as a hedge, and how another FC can potentially fit into our market conditions.
In a study conducted by David Easley (Cornell), Marcos M. Lopez de Prado (Tudor Investments), and Maureen O’Hara (Cornell), some of the major causes are identified (link to the Study). What they found is that the ratio of informed trading volume to total volume had been elevated for days prior to the FC. The metric they used to measure this, also developed by the group, is called the VPIN or Volume-synchronised Probability of Informed Trading.
There are of a lot of ways to define the VPIN, here’s the way I find easiest: It is a ratio; the numerator is the absolute difference between buy-volume and sell-volume which is basically a measure of toxicity for maker makers*; the denominator is the total trading volume. The intriguing part about the VPIN is that it displayed elevated levels for a couple days before the FC occurred and ultimately peaking on May 6th, which means its predictive not reactive. When the VPIN is increasing, one to several things may be happening, here are a few (these reasons are FC specific):
-Total trading volume may be falling; this decreases the denominator and increases the ratio.
-Retail investors are trading less. This increases the numerator, because the population of active traders in the market then contains a higher percentage of informed-traders overall, such as hedge fund traders. Retail investor trading decreased due to the market crash a year earlier and the economic downtown. This will also decrease the denominator, thus elevating the ratio dually fast and consuming liquidity.
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