Question

On May 6, 2010, the US stock market experience what is called “Flash Crash,” in which DJIA plunged about 1000 points (about 9%) only to recover those losses within minutes. Some people say that the crash was due to the high-frequency traders. What do you think about the market efficiency in the flash crash? Is the flash crash evidence against the market efficiency? Do you think high frequency traders make the market more volatile and as a result inefficient?

Answer 1

What is Flash crash

A flash crash is an event in electronic securities markets wherein the withdrawal of stock orders rapidly amplifies price declines. The result appears to be a rapid sell-off of securities that can happen over a few minutes, resulting in dramatic declines. A flash crash, like the one that occurred on May 6, 2010, is exacerbated as computer trading programsreact to aberrations in the market, such as heavy selling in one or many securities, and automatically begin selling large volumes at an incredibly rapid pace to avoid losses. Flash crashes can trigger circuit breakers at major stock exchanges like the NYSE, which halt trading until buy and sell orders can be matched up evenly and trading can resume in an orderly fashion.

More Information on flash crash

Shortly after 2:30 p.m. EST on May 6, 2010, a flash crash began as the Dow Jones Industrial Average fell more than 1,000 points in 10 minutes, the biggest such drop in history, at that point. Over one trillion dollars in equity was evaporated, although the market regained 70 percent by the end of the day. Initial reports that the crash was caused by a mistyped order proved to be erroneous, and the causes of the flash were attributed to a Navinder Sarao, a futures trader in the London suburbs, who plead guilty for attempting to "spoof the market," by quickly buying and selling hundreds of E-Mini S&P Futures contracts through the Chicago Mercantile Exchange.

There are have been other flash crash type events in recent history wherein the volume of computer generated orders outpaced the ability for the exchanges to maintain proper order flow:

• August 22, 2013. Trading was halted at the Nasdaq for more than 3 hours when computers at the NYSE could not process pricing information from the Nasdaq.
• May 18, 2012 - Facebook's IPO. While not a flash crash per se, Facebook shares were held up for more than 30 minutes at the opening bell as a glitch prevented the Nasdaq from accurately pricing the shares causing a reported $460 million in losses

Corrective measures should be required to be taken to reduce these difficulties-

As securities trading has become a more heavily computerized industry driven by complicated algorithms across global networks, the propensity for glitches, errors and even flash crashes has risen. That said, global exchanges like the New York Stock Exchange, Nasdaq and the CME have put in place stronger security measures and mechanisms to prevent them and the staggering losses they can lead to. They cannot eliminate them altogether, but they have been able to mitigate the damages they can cause.The first is the involvement of high-frequency trading firms. Though their existence was known to professional traders and money managers, these firms were not in the public spotlight. Their ability to trade quickly has increased the speed at which breaking news is priced into the market. This arguably makes the market more efficient, especially for securities with higher levels of trading volume. It also makes day trading even more risky for individual investors than it previously was.There is still more information but I think it is relevant for your question.

A second point is that how you place an order matters greatly. Investors who had standing orders to sell a stock or exchange-traded fund if it fell below a certain price learned the risks of such orders on May 6, 2010. As Chris Nagy of TD Ameritrade explains in the new issue of the AAII Journal, a stop order turns into a market order once triggered if more specific instructions are not given. During the flash crash, prices fell rapidly and many orders were executed at what turned out to be artificially low prices.

An alternative to a plain stop order is a stop-limit order, which includes a minimum price at which you want to sell the stock. This is not without risk either, as a stock could fall below the minimum price you want to sell at without your order being executed. Put options (a contract to sell the stock at a future date) lock in a sell price, but increase costs, especially since they expire worthless if not executed.