Flash Crash: Definition, Causes, History

What Is a Flash Crash?

The term flash crash refers to an event where prices of the overall market or a particular stock decline rapidly then recover quickly, sometimes within the span of minutes.

The cause of a flash crash is typically a rapid sell-off of securities, resulting in dramatic price declines. However, as prices rebound by the end of a trading day, it can appear as if the flash crash never happened.

How Flash Crashes Work

Flash crashes occur when securities prices make drastic drops and rebound very quickly, typically within a single day. This was the case when the U.S. market experienced a sudden drop on May 6, 2010 and recovered within a short span.

As trading becomes more digitized, flash crashes are usually triggered by computer algorithms, as opposed to specific market or company news that might prompt a quick sell-off. With the emergence of high-frequency trading, computer programs can automatically react to economic conditions by selling large volumes of securities at an incredibly rapid pace to avoid losses. This in turn leads prices to drop.

As prices fall, more benchmarks might be triggered, creating a domino effect that results in a steep plunge in value. Today, more research is required on flash crashes, including whether they may indicate fraudulent activity.

Flash crashes can trigger circuit breakers at major stock exchanges like the New York Stock Exchange (NYSE), which halt trading until buy and sell orders can be matched up evenly and trading can resume in an orderly fashion.

Preventing a Flash Crash

The risk of flash crashes occurring has increased as securities trading has become a heavily computerized industry driven by complicated algorithms across global networks. In response, global exchanges like the NYSE, Nasdaq, and the Chicago Mercantile Exchange (CME) have implemented security measures and mechanisms to prevent them and their associated losses.

For example, some exchanges have put in place market-wide circuit breakers that trigger a pause or complete stop in trading activity in response to declines of a certain threshold: A decline of 7% or 13% in a market's index from its previous close halts trading activity for 15 minutes; a crash of more than 20% halts trading for the rest of the day.

The Securities and Exchange Commission (SEC) has also banned naked access or direct connections to exchanges. High-frequency trading firms, which have been blamed for precipitating the flash crash's effects, often use their broker-dealer's code to access exchanges directly. Such measures cannot eliminate flash crashes altogether, but they have been able to mitigate the damages they can cause.

Examples of Flash Crashes

One of the most famous examples of a flash crash in recent history occurred on May 6, 2010, beginning shortly after 2:30 p.m. During the flash crash, the Dow Jones Industrial Average (DJIA) fell more than 1,000 points in 10 minutes—the biggest drop in history at that point. The index lost almost 9% of its value within the hour. Over $1 trillion in equity evaporated, although the market regained 70% the loss by the end of the day.

Initial reports claimed that the crash was caused by a mistyped order, but that theory later proved to be erroneous. The flash was later attributed to Navinder Singh Sarao, a futures trader in the London suburbs, who pled guilty for attempting to spoof the market by quickly buying and selling hundreds of E-Mini S&P Futures contracts through the CME.

Other Flash Crashes

There have been other recent events resembling flash crashes, wherein the volume of computer-generated orders outpaced the ability of the exchanges to maintain proper order flow. These include:  

• August 22, 2013: Trading was halted at the Nasdaq for more than three hours when computers at the NYSE could not process pricing information from the Nasdaq.
• May 18, 2012: While not a flash crash per se, Meta (formerly Facebook) shares were held up for more than 30 minutes at the opening bell as a glitch prevented the Nasdaq from accurately pricing shares during its initial public offering (IPO), causing a reported $500 million in losses.

The Bottom Line

A flash crash is a type of stock market crash, in which prices plummet then rebound rapidly. Flash crashes are typically attributed to high-frequency trading, which enables the automatic buying and selling of securities in large volumes. Regulatory authorities have taken efforts to curb the risk of flash crashes, though per one estimate, there are about 12 mini flash crashes per day.