So I guess the fortune teller's right
I should have seen just what was there
And not some holy light
--Natalie Imbruglia
Last week someone hacked into the Associated Press Twitter account and tweeted that the White House had been bombed. In less than a minute, the S&P sank about 20 handles before snapping back after the fake tweet was refuted.
Punctuated by the May 2010 'flash crash,' the phenomenon of big, sometimes sudden downdrafts are becoming notewothy in indexes and individual issues alike.
Rick Santelli et al discuss them in light of how market structure has evolved over the past decade or so. Previously, markets were dominated by a few high volume exchanges that attracted huge numbers of buyers and sellers. Today that concentrated model has been replaced by a fragmented model where many smaller exchanges operate in a satellite configuration with fewer buyers and sellers populating each exchange.
On the surface, the previous concentrated exchange model seems superior from a liquidity standpoint. Because it attracted many buyers and sellers, the concentrated exchange structure provided 'deep pools' of buyers and sellers seemingly capable of absorbing large waves of selling during times of market stress. Conversely, the 'shallow pools' of the fragmented model seem less capable of absorbing big supply.
However, the concentrated-to-fragmented evolution in market structure cannot satisfactorily explain the increasing flash crash phenomenon. If buyers in a particular satellite market complete dried up and prices began plummeting in a 'bid wanted'-like situation, then modern arbitragers electronically scanning the various exchanges for mispricings will quickly seize the opportunity and operate to close the price gap between one market and the others.
In fact, it could be argued that fragmented markets reduce the risk of flash crashes in the sense that the behavior of buyers and sellers is less correlated--at least in the very short term. Because the price action can vary between exchanges and arbs can diminish price gaps that theoretically shouldn't exist, then the fragmented exchange model should be more resistant to 'bid wanted' downdrafts.
Other structural factors are likely in play. We'll consider some more in a future post.
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Our analysis of the Waddell & Reed e-Mini trades led us to an unexpected break-through. By process of elimination, and with the SEC report for context, we finally have a crystal clear understanding what caused the May 6, 2010 flash crash.
First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.
The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could. The sale was so furious, it would often clear out the entire 10 levels of depth before the offer price could adjust downward. As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.
Because of arbitration, when the e-Mini changes price with high volume, many ETFs are repriced (quotes updated, trades executed). The component stocks of ETFs are also repriced, along with many indexes. And finally, all the option chains for the ETFs, their components and indexes are also repriced. The entire system simply cannot absorb the impact of a sudden move in the e-Mini on high volume. A sale (or purchase) of 2,000+ contracts which rips through one-side of the depth of book in 50-100 milliseconds, will immediately overload many systems. The impact reverberates for a much longer period of time than the sell (or buy) event itself.
The first large e-Mini sale slammed the market at approximately 14:42:44.075, which caused an explosion of quotes and trades in ETFs, equities, indexes and options -- all occurring about 20 milliseconds later (about the time it takes information to travel from Chicago to New York). This surge in activity almost immediately saturated or slowed down every system that processes this information; some more than others. Two more sell events began just 4 seconds later (14:42:48:250 and 14:42:50:475), which was not enough time for many systems to recover from the shock of the first event. This was the beginning of the freak sell-off which became known as the flash crash.
In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive, low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear.
~Source: Nanex (Please note that complete analysis may be found at nanex.net)
Today's flash crash example: Symantec (SYMC)
dropped 10% in just over 1 second on 500,000 shares. Trades executed on 13 exchanges and an unknown number of dark pools. The drop tripped a circuit breaker, prompting a 5 minute halt. After the halt, the price immediately recovered most of the drop.
~Source: Nanex
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