The 2010 Flash Crash

Why this matters

On the afternoon of May 6, 2010, major US stock indices, already down over 4% for the day, suddenly fell a further 5% to 6% in a matter of minutes before rebounding almost as quickly. In those minutes, more than 20,000 trades in over 300 stocks and exchange-traded funds went through at prices 60% or more away from where they'd been just before, some at a penny a share and some at $100,000.¹ The cause wasn't new information about companies or the economy but the way buy and sell orders met, or failed to meet. It's the clearest case of a market breaking down because of how trading works, and it's why US stock markets now have automatic price bands and pauses.

A nervous market

The day opened to unsettling news about Europe's debt crisis, and the cost of insuring against a Greek default rose. Around 1 p.m. the euro began falling sharply. By 2:30 p.m. the VIX volatility index was up 22.5% from its opening level, investors were buying Treasuries in a flight to quality, and the Dow Jones Industrial Average was down about 2.5%. Buy orders waiting in the S&P 500 futures market, the E-Mini, had fallen 55% from the morning, to about $2.65 billion.¹

The sell order

At 2:32 p.m., a mutual fund company began selling 75,000 E-Mini contracts, worth about $4.1 billion, to hedge its stock holdings. It used an algorithm set to sell 9% of the previous minute's trading volume, without regard to price or time. The last time this trader had sold that many contracts, it took more than five hours. This time the algorithm finished in about 20 minutes.¹

High-frequency traders bought much of the first wave, then began selling to cut their positions. Between 2:45:13 and 2:45:27 p.m., they traded over 27,000 contracts, about 49% of all volume, while adding only about 200 contracts to their net holdings: they were passing contracts back and forth. The rising volume made the algorithm sell faster, even though few new buyers had arrived. From 2:41 to 2:45:27 p.m., E-Mini prices fell more than 5%. By 2:45:28 p.m., buy orders in the E-Mini had shrunk to less than 1% of their level that morning.¹

Minute	Contracts traded in the market	Algorithm sells next minute (9%)	New buyers who actually want to hold
1	20,000	1,800	2,000
2	40,000, as traders pass contracts around	3,600	1,500
3	70,000	6,300	1,000

Volume rises because the same contracts change hands again and again, not because buyers are arriving. An algorithm that reads volume as a sign it's safe to sell faster speeds up exactly when real demand is shrinking, and the gap between selling and genuine buying has to be closed by falling prices.

At 2:45:28 p.m., the futures exchange's automatic safeguard paused E-Mini trading for five seconds. When trading resumed, prices stabilized and began to recover.¹

The rest of this lesson is for members

Still to come in this lesson: Pennies and $100,000, What changed, the key takeaways, and 2 quiz questions with explanations.

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