Why the Flash Crash Really Matters
At about 2:30pm on May 6, 2010, an asset management firm began executing a series of orders on the Chicago Mercantile Exchange. Located in Overland Park, Kansas, Waddell & Reed was (and is) one of the oldest mutual fund companies in America. It followed a strategy based on fundamental analysis—Wall Street code for old-fashioned investing. That afternoon, it wanted to sell 75,000 futures contracts on the S&P 500, a major market index, before the market closed at 4 p.m. The order was large but basically unremarkable, and Waddell & Reed had been executing similar trades for decades.
But this time something was different. Within 20 minutes of Waddell & Reed’s initial order, S&P 500 futures had declined 5 percent, and individual equity prices began to oscillate wildly. The price of the consulting firm Accenture declined from roughly $30 to $0.01 in seven seconds. Consumer goods giant Procter and Gamble dropped from around $60 to $39. Shares of Apple tumbled 20 percent from their pre-crash price of approximately $250, and also traded at nearly $100,000 per share (trades which were later annulled by the exchange). The dramatic futures move and the massive and sudden dislocation in the equities markets on that day came to be known as the Flash Crash.
How did the Flash Crash happen? The Securities risk by selling these same futures. Other automated traders took the other side of these trades, then also sought to offload their risk in the market. Each trade that Waddell & Reed made therefore caused multiple trades in response. In addition, Waddell & Reed had instructed their own trading program to trade no more than 9 percent of the total volume of the futures contracts traded at any given time, so that their algorithm didn’t trade too aggressively. But the algorithm wasn’t given any restrictions on price, or the time it should take to finish its order. It began to ramp up its own volumes exponentially in response to the activity that it itself had initiated, all the while maintaining its 9 percent volume cap. As the firms buying from Waddell & Reed accumulated risk, they began to require more incentive to continue buying futures. Prices began to fall. And since the different firms that were trading with Waddell & Reed’s orders also were generally using similar algorithms, their behavior became strongly correlated, pushing the markets in the same direction: down.
