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'Flash crash' report: A tale of how not to make a big trade

The May 6 'flash crash' of the stock market was set off by a single $4.1 billion 'sell' order, the SEC reported Friday.

By Staff writer / October 1, 2010

From right, Commodity Futures Trading Commission Chairman Gary Gensler, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Timothy Geithner, FDIC Chair Sheila Bair, and Securities and Exchange Commission Chair Mary Schapiro, meet Friday at the Treasury Department in Washington.

Pablo Martinez Monsivais/AP

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The US stock market briefly went haywire on May 6, and a key reason for this so-called "flash crash" was a single large "sell" order, according to a report Friday by the US Securities and Exchange Commission (SEC).

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It's a cautionary tale about the complexity and potential vulnerability of America's financial markets. But in the end, it's also a simple lesson for large and small investors alike: If you're going to trade, be careful how you do it.

At the heart of the incident, as the report recounts, was a single poorly designed trade. As a result, many stock prices swung sharply downward just after 2:30 p.m. and then shot upward to recover most of those losses by 3 p.m.

"A customer [investor] has a number of alternatives as to how to execute a large trade," said the report, prepared by the Commodity Futures Trading Commission (CFTC) as well as the SEC. "This large [mutual fund company] chose to execute this sell program via an automated execution algorithm ... without regard to price or time."

The mutual fund company is not named in the report, but independent media accounts have identified the firm as Waddell & Reed in Overland Park, Kansas.

The trade was a sell order on "E-Mini" contracts on the future price of the Standard & Poor's 500 stock index. It misfired for three reasons:

  • It was a large order, "the largest net change in daily position of any trader in the E-Mini since the beginning of the year," the SEC said. This came on a bad day, when investors were already tense -- and selling -- due to negative news about the European debt crisis.
  • The algorithm was set up so the firm would keep selling regardless of price. When prices veered into territory that was irrationally low, based on the consensus view of traders that day, the selling continued.
  • The computerized trade was also set up with no speed limit, so the selling pressure surged through the market at a speed that made it hard for other players to respond. By contrast, when the same company placed a large sell order some months earlier, the algorithms "took into account price, time, and volume" and the trade unfolded over a period of at least five hours.

The 104-page report doesn't answer all of the mysteries of May 6 – why some securities swung much more wildly than others, for example.

But it does go into new detail about how the E-Mini trade rippled through financial markets.

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