What REALLY Caused The Flash Crash?


May 6th already seems like a distant memory for some of us. During a 20 minute period on that fateful day, the Dow dropped 1,000 points, temporarily wiping out nearly $1 trillion in value. And then recovered most of its mysterious losses before closing bell. The E*Trade day trader baby almost certainly soiled itself in the interim.

What actually caused it? And how can you protect yourself (and even profit) from another flash crash?

Theories at the time ranged from plausible to mundane to outright paranoid. Some believed the crash was caused by high-frequency trading shops around the country suddenly entering “HF STOP” (sell everything and cease trading) into their terminals.

This is a bit like saying the aeroplane crashed because passengers used the emergency exit row slides.

Another theory blamed a “fat finger” episode for the sudden death spiral toward U.S. financial oblivion. In other words, a single careless trader with a remarkably obese, twitchy finger may have entered additional zeros in his trade by accident.

Sounds too much like the opening scene of a House episode.

Yet another theory placed the blame squarely on Chinese-sponsored or rogue hackers, hell bent on the destruction of the United States’ financial markets. This one also turned out to be not true, as the SEC has since stated that they “have not identified any information consistent with computer hacker or terrorist activity.”

(Although if it was a cyber attack, I doubt the SEC would admit their blind spot until appropriate circuit breakers and work-arounds have been implemented.)

As it turns out, the “fat finger” theory may not have been terribly off the mark in the sense that a sole trader was behind it. According to Here is the City, the “trader concerned didn’t work in a hedge fund or for a high-frequency trading firm (as many suspected), but, according to a document the news agency claims to have seen from Chicago Mercantile Exchange parent CME Group Inc., rather US money manager Waddell & Reed Financial.”

The firm is said to have sold 75,000 e-minis during a 20-minute period and the trades appear to be part of a legitimate hedging strategy.

This apparently legitimate transaction spooked the market, sending shock waves through financial circles in a matter of minutes.

How can you protect yourself from another flash crash? Jim Cramer, who probably made CNBC viewers easy afternoon money by telling people to go out and buy P&G, in June said that “nothing’s fixed” in regards to preventing another hell cascade.

I think the flash crash is evidence that our electronic financial system is prone to seizures in liquidity and sharp sell-offs. So keep a sizable amount of cleared, available cash in your brokerage account at all times so that — in the event of another visit from the flash crash fairy — you can swiftly load up on your favourite Dow stocks at Wal-Mart remainder bin prices. One way to trade on this would be to have limit orders ready to buy that are deep out-of-the-money.

While everyone else is panicking, just close your eyes and buy. The worst that can happen is the exchange reverses your trades, in which case, no harm done. But if the trade sticks, you could wind up with a fast 50 to 60 per cent return.David Seaman is a writer at the Wall Street Memo, a site that offers research and analysis for investment managers and financial professionals.

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