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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.

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The big sell order sparked price swings in broad market indexes and indirectly in individual stocks. Firms that normally provide liquidity – buying securities when others sell – pulled back. Then, over time, various investors stepped in with buy orders as they concluded that the rapid plunge in stock prices did not reflect fundamental news.

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The Dow Jones Industrial Average, which was down as much as 9 percent for the day in mid-afternoon, ended the day with a loss of 3 percent, about the same as its level just before Waddell & Reed put its trade in motion.

The large order, placed at 2:32 p.m., was to sell a total of 75,000 E-Mini contracts, a total trade worth about $4.1 billion. The algorithm was set up to keep selling contracts, as long as trading volume was strong, until all those contracts were sold. As a result, the algorithm ended up selling the whole bundle in just 20 minutes, with sales flowing faster than other firms could absorb them.

In reporting on the events of May 6, the SEC produced a "what happened" document, rather than detailed prescriptions for how markets can function better.

Still, the agency pointed to some broad lessons, and said its report confirmed the wisdom of a new "circuit breaker" system that the SEC and exchanges have put in place since May 6.

"May 6 was ... an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products," the report concluded. The E-Mini, as a futures contract, is considered a derivative investment.

Another lesson is that a liquidity crisis can develop in ad hoc fashion, as various firms pause from trading due to their own criteria. They aren't knowingly contributing to a market meltdown, but it becomes a problem if many buyers take a pause when there's also high selling pressure.

The circuit breaker concept involves a mandated pause in trading, which gives various players time to get back on top of a volatile situation. It puts the market on hold at a time when some traders might be taking a pause anyway, due to uncertainty.

What's new since May 6 is circuit breakers for trading in individual securities, not just for the overall market (if major indexes take a rapid plunge). Trading in a stock will halt for five minutes if that security has experienced a 10 percent price change during the preceding five minutes.

The SEC has also worked with exchanges since May to develop a more systematic approach to resolving "erroneous trades." In the past, regulators have canceled some trades after the fact, when they concluded that transaction prices were far outside normal bounds for a given day. But the process has been controversial and because traders can gain or lose from these "broken trades."

Like the new circuit breakers, the process for broken trades is in effect on a pilot basis for now, through Dec. 10.

Even with those steps, the events of May 6 have raised doubts among many small investors about whether markets are reliable and fair.

SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler issued a brief joint statement Friday designed to assure investors that they are on the case: "We now must consider what other investor-focused measures are needed to ensure that our markets are fair, efficient and resilient, now and for years to come."