Please ensure Javascript is enabled for purposes of website accessibility

Flash Crash 2.0

By Doug Ehrman - Apr 24, 2013 at 2:05PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The Twitter-induced panic compared to the flash crash of 2010.

Anyone who was sitting at a trading desk on May 6, 2010 -- as I was -- remembers the flash crash as one of the most unusual trading days ever recorded. While on a much smaller scale, yesterday's Twitter-induced mini flash crash, or "flash crash 2.0," is likely to have important ramifications. Not only have structural weaknesses in the nature of trading news been highlighted, but the potential impact of weak security in social networking will be discussed in a new light. The ensuing investigation, which will primarily focus on the hackers who initiated the bogus tweet, may reveal a great deal about how market structures need to be addressed.

Flash crash 1.0
The first flash crash was determined to have been caused by the sale of a large block of S&P 500 (^GSPC 0.95%) e-mini futures contracts, triggering cascading program-trading that resulted in a 9% drop of the overall market. Essentially, the initial sale triggered various computer models to hit critical levels. When these levels were hit, sales were entered, driving prices lower. The mythical self-fulfilling prophecy came to Wall Street and drove things crazy long enough to wreak havoc.

There was no intentional wrongdoing detected in the first flash crash, but the impact was felt by many. Trades in certain names were canceled and deemed "erroneous." The problem was that many traders bought and sold as prices spiked, and not all trades were canceled. Depending on which trades were allowed to stand for a given name, you might have made a lot or lost a lot, depending on the level selected for trade cancellation. After the event, new circuit-breakers were put in place to halt trading if too rapid a decline occurred.

How was this time different?
The second flash crash was caused by the intentional manipulation of information when hackers used the Associated Press' Twitter account to post a fictitious report about two explosions at the White House that injured President Obama. The S&P 500 fell nearly 1% in three minutes, even though it ultimately closed higher by more than 1%. It is too soon to determine what action, if any, regulators will take either to adjust circuit breakers or to tighten the flow of information from the major social-media sites, but these are the developments that could have the most lasting impact.

The reaction to the bogus report demonstrates that not only the flash crash, but memories of September 11, have had a lasting impact. The reaction to the terrorist attacks on September 11 was slow, with only a limited number of traders reacting before trading was halted. Those who immediately sold on the news were rewarded for their vigilance, but a dangerous precedent was set: Terrorism news is likely to incite panic-selling before facts are checked.

Perhaps the most interesting, and arguably tragic, observation that can be made is that where news of an attack on the White House caused an immediate reaction, the market reacted rather tamely to the Boston attacks. While the impact of a White House attack would be drastically greater, it is worth considering whether any structural changes are suggested based on the Twitter-crash.

After the all-clear
In the aftermath of another rollercoaster dip in the market caused by an aberration, the question is what regulators should do. Tightening circuit-breakers might be an initial idea, particularly among nonprofessional traders; the amount of wealth that vanished in three minutes seems an unfathomable toll for a prank. The problem with this reaction is that at some point, if controls are too tight, the price-discovery function of the market is lost. The free market only works if it is free. A 1% negative spike is significant, but it should not cause the same amount of concern as the 9% dip that resulted from the first flash crash. Ultimately, leaving things alone makes more sense.

Perhaps the bigger concern is of how information is handled. While there is little chance that regulators will be able to prevent the flow of news through social media, there is the possibility that they will address automated trading based on these feeds. An anecdotal cause of flash crash 2.0 was selling caused by programs that are triggered by algorithms that read news and react accordingly. For example, if the correct combination of "terrorist," "explosion," and "White House" are detected enough times in certain feeds, sell orders are placed. There is a real possibility that regulators may adjust the rules surrounding these types of automated trading, making the argument that the systematic risk created outweighs the freedom typically given to market participants. This is a slippery slope, and regulators are prone to overreaching.

Overall, seeing how the investigation plays out will reveal the true significance of flash crash 2.0 and where we might see things change as a result.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,978.73 (0.95%) $37.25

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
322%
 
S&P 500 Returns
116%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/25/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.