SAN DIEGO (ETFguide.com) - I have good news and bad news. Here's
the good news: The May 6th 'Flash Crash' that spooked global
markets is over. Now for the bad news: It's exact causes still
aren't known and could reoccur.
What was the 'Flash Crash' and how did it happen? And moreover, how
likely is another similar episode in the future? Let's investigate
The Anatomy of an Epic Decline
The 'Flash Crash' on May 6th triggered a massive decline in stocks
and sent shockwaves throughout global financial markets. The Dow
Jones Industrial Average (NYSEArca: DIA), a barometer of 30 U.S.
blue chip stocks, fell a record 998.5 points or 9.2% in value.
Other leading market indexes like the S&P 500 (NYSEArca: SPY)
and Nasdaq Composite (NasdaqGS: ONEQ) were also hammered.
Among the most surprising aspects of the 'Flash Crash' was the
suspicious trading activity of certain stocks. Procter and Gamble (
) fell almost 37% before quickly rebounding. Other stocks like
) and Exelon (
) briefly traded for cents.
And perhaps the most amazing part of the stock market's colossal
decline on May 6th wasn't the $1 trillion that temporarily
vanished, but its unprecedented immediately rebound. By the final
15 minutes of the trading session, stocks reversed their intraday
losses. When, besides never, has this ever happened in stock market
Questions and Answers
There are various explanations of why the 'Flash Crash' occurred
and virtually all of them are unsatisfactory. The Wall Street
Journal suggested a large order of put options by a hedge fund
might have been a factor. Another report claims a $4 billion trade
of e-mini contracts on the Chicago Mercantile Exchange was at
fault. Others blame an errant trade made by someone that pressed
the wrong button their keyboard.
In Congressional testimony, S.E.C. Chairwoman Mary Schapiro said
'stub quotes' may have caused certain stocks to trade for 1 cent a
share. 'The absurd result of valuable stocks being executed for a
penny likely was attributable to the use of a practice called stub
quoting,'' she stated. 'When a market order is submitted for a
stock, if available liquidity has already been taken out, the
market order will seek the next available liquidity, regardless of
price. When a market maker's liquidity has been exhausted, or if it
is unwilling to provide liquidity, it may at that time submit what
is called a stub quote - for example, an offer to buy a given stock
at a penny. A stub quote is essentially a place holder quote
because that quote would never - it is thought - be reached.'
While Schapiro's explanation sounds intellectually smart, she
never explained why the S.E.C. allowed harmful stub quotes to exist
in the first place. Since then, the S.E.C. has moved to ban the
Finding a Cure
Any honest doctor will openly admit it's difficult to cure a
problem when you don't know its exact causes. In fact, prescribing
medication without knowing the source of the patient's problem
could endanger their life. None of this, of course, has stopped
Wall Street's cop, the S.E.C., from prescribing a wide range of
Better communication and oversight among the public exchanges
that list securities and derivatives is being tried.
Among the other fixes being tested are trading cubs also known
as circuit breakers. The system acts as a sort of fire alarm that
automatically halts trading for five minutes on any S&P 500
stock that rises or declines more than 10% within a five-minute
How well have the fire alarms been performing?
On June 2nd, the share price of Diebold (
) briefly fell 35% before circuit breakers went into effect. In
other words, the problem of market crashes in both individual
securities and broadly diversified benchmarks still hasn't been
Do you believe in tame lions and tigers? How about tame