How a Flash Crash Works
A flash crash just cut short Virgin Galactic’s crazy space voyage. A quarter of the company’s market cap was shed after shares broke the $40 barrier, all in just forty-five minutes. Actually, this isn’t the first mysterious blip that markets have suffered.
9% of wealth on the US stock market was decimated for a 36 minutes back in 2010, in what’s now remembered as the ‘flash crash of 2:45.’ The trillion-dollar dip brought out central banks and resulted in congressional hearings and academic studies, but someone’s “fat finger” was the only verdict. The causes of Virgin Galactic’s drop may be too imprecise and potentially irrelevant if the stock moves double-digits again today. However, flash crashes are more common now than ever before, and it’s because buying a stock isn’t how it used to be.
Whereas before a New Yorker would scurry and squeal across a hectic trading floor with you on the other end of the phone, now everything’s computerized. Every request to trade ‘Ted’s Widgets’ is thrown into the same bowl, no matter the demanded price or attached strings. It’s for an algorithm to keep the train moving!
Say an investor wants to sell one million shares of Ted’s Widgets for $100 each. That’s a lot of shares. There probably isn’t the volume of buyers out there to offload all those shares at once, so while 500,000 sell orders may be instantly fillable at the asking price of $100, the computer will need to go looking for demand to sell the other 500,000 at the next best prices available (unless a human steps in).
300,000 shares may end up going to buyers waiting to buy at $99, and the other 200,000 shares could be sold even lower. Some traders, for instance, might have lowballed the market with orders at $95 or $94 in recent weeks, allowing their requests to sit there just in case a scenario like this came along. No matter how deep the computer reaches, the share price of Ted’s Widgets trends down with the filled order levels.
A flash crash occurs when a blind computer collides with a fat cat investor. Ted’s Widgets may not be a big enough company for the big investor’s last few shares to find reasonable buyers. But that’s no problem for the system. It’ll just resort to the unreasonable buyers!
Jimmy’s Buffett’s dormant $4.20 buy order from 2014 will resurface, get filled, and for just a fleeting tick, the stock price will dive to $4.20. That’s when all hell breaks loose (a Jimmy Buffett gets an amazing trade)!
Now, usually there are circuit-breakers, stub quotations, limit-up-limit-down protectors, and even restrictions on the lowest possible buy orders allowed to stop this happening. However, some financiers believe in an iron law of supply and demand. Sticklers for raw capitalism insist that investors play without padding, what’s subjectively viewed as “reasonable” not relevant in a free market system. This is what’s going on in some unregulated crypto exchanges at the moment. It’s a fair attitude, but is it how you feel?