Flash Crash 3 year Anniversary

by Jay Pestrichelli on May 6th, 2013

As the market pushes to new highs this morning, today, May 6th 2013 is the 3 year anniversary of the “Flash Crash”. For those of you scratching your head asking “How did that Flash Crash thing happen again?”  you are still waiting for an answer to that question. That is because it was, in fact, a day when form a systemic and operational aspect nothing went wrong.  It was the result of a massive wave of seller and removers of buy orders that took the floor right out of the stock market. Trigger after trigger had automatic trading systems reacting faster than humans could and in a flash (20 minutes) the DOW dropped nearly 1,000 points.
 
Since that time new curbs have been instituted to slow down single stocks from selling off too quickly and they are used on a very regular basis. We may not hear about them as they are on small stocks, but from time to time we’ll hear about a stock being halted in the middle of the day due to some news or event that wouldn’t have existed before.
 
Will this stop future flash crashes?  The answer is probably not. There seem to always be situations that have no preventative pre-existing precautions in place. As market participants get more and more sophisticated there will always be plenty of looking back trying to digest what actually happened. Look back to April 23rd, just two weeks ago, when the false tweet from the Associated Press came out. The market sold off 1% in 2 minutes. Not large enough for any of the curbs to kick in, but an example of how automated trading systems can pull back orders and leave no buyers to provide support resulting in a quick down move. 
At Buy and Hedge, we don’t think the system is broken, however, but we do think it has its vulnerabilities.  We can point to many events over the past few years that continue to show how the system is imperfect. As both my co-blogger and I know, the every-day investor will always find themselves as casualties of the larger institutions mistakes.  Don’t get us wrong, the institutions get hurt too, and in a much bigger way; but the pain to the individual always stings the worst.  This is why we wrote our book. This is why we think everyone should be hedged.
 
During days when the system breaks down, things like stop orders don’t provide the right protection for two reasons. First, the system you’re relying on protecting you is the thing that is failing. The time it takes to trigger your stop order can be too long when talking milliseconds and you can find your stops never get filled because the market has moved through them. Second, if you do get filled, you may find that you’ve sold near the bottom of the quick move and completely miss the snap back to the up side.  In the case of May 6th 2010, that is exactly what happened. Many who relied on stop orders exited near the low and found themselves having to buy back at higher prices.
 
All this is information we’ve talked about before, but here’s something you might not have seen, which is what the VIX told us BEFORE the flash crash.
 
7 days leading up to the flash crash, the VIX had moved from 17 to 25. This was done on no apparent sell off. The S&P was bouncing between 1210 and 1185 up until the day before when a little additional weakness pushed it lower to 1170. A 2% move over a week isn’t anything to build fear, but the options market was reflecting it in the VIX. See below.
There is a little chicken or the egg situation here. Did the volatility cause the severity of the crash or did the dropping market simply reflect itself in the options early. I’m going to leave of the conspiracy theories out of this because no one has ever suggested that the market was manipulated in anyway on that day.  I’m in the camp that the severity of the selloff was a result of a skidish market and that fear first showed itself in the VIX the week ahead of time. In other words, the market community was ready for a sell off and just needed a trigger to kick into place.
 
This is not the first time we’ve seen this. A look at the VIX going into the tradgedy of 9-11-2001 the same was evident. Again, I’m not positioning this for a conspiracy theory discussion, but leading up to the terrible events of those days the VIX had moved from 20 to 32. There was a 7% sell off ahead of 9-11 that helped cause that rise in the VIX, but that rarely gets discussed. However, I use it as an example of how the market was poised for a sell off.
Let's look at one last example, the Boston Marathon bombing. I’ve received a lot of questions recently about why the market didn’t collapse in the face of a feared terrorist event. Leading up to that day, the VIX was in decline as the markets were still rising to new highs. That day, however, started out to be negative before anything happened at the marathon. And yet, after the bombs went off, we only saw an additional 1% decline in the markets. Some of the muted market reaction can be attributed to the low VIX. I’ll say it another way…the market just wasn’t poised for a sell-off and the market community wasn't waiting for a trigger to do so..
Let’s boil this all down to something useful. Can you use the VIX to predict when the market is ready to sell-off? The answer is maybe. (I know, not helpful). There are plenty of times where a rising VIX didn’t predict a market correction.  What we are pointing out here is that there can be a predisposition for the fear of the market to reflect itself in options and to be aware of that.
 
But we caution you to not use this as your only guideline. Take a look back at August 4th 2011 for example. The options market had no idea that some of the most volatile back-to-back days in history were right around the corner. If you were relying on the VIX to save you then, you would have found yourself in the wrong position for way too long. (Dramatic Pause…) This is why we hedge.


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