Anatomy of a Flash Crash
On Monday, May 2, a computer-driven “Flash Crash” wiped out $315 billion from the Stockholm Stock Exchange in just five minutes.
And 12 years earlier, in this same week, the first infamous Flash Crash struck the New York Stock Exchange and drove stocks down 1,000 points in just 10 minutes.
But how do they work?
With waterfall declines and split-second crashes becoming more and more common, I’m here to show you how to stay one step ahead of the machines…
Click here to watch this week’s video or click on the image below:
Hey everyone, Clint Lee here with your, Big Picture, Big Profits Friday video. First things first, please like and subscribe to our channel. I would love to have your comments below on today’s topic. Now, about that topic. I want to go back in time just a little bit, just a few days. I want to go back to the start of this week.
It seemed like a normal start to the week. Normal, at least, given the circumstances and challenges facing the world today.
House Speaker Nancy Pelosi was visiting Ukraine for a photo-op with President Zelensky. Chatter around the Federal Reserve meeting this week was starting to pick up.
Stocks, they were beginning to recover from a really rough Friday last week, a trading session that saw the Dow Jones drop by over 900 points. Which, by the way, I wasn’t aware of this until someone pointed it out, that’s its 15th largest point drop in history.
But then, over in Europe, around noon, traders were heading out for lunch, unaware that a much different kind of crash was stalking the market. It was one that would eventually wipe out about $315 billion in only five minutes. Once again, over $315 billion in just five minutes.
$315 Billion Stock Market Crash in Just 5 Minutes
Take a look at this:
Over in Europe, Stockholm’s index plunged by 8% in just five minutes, before recovering most of those losses. That caused absolute havoc on other European indexes as well. Turns out, it was a fat-finger trade. It was human error, human error that was actually made worse by some other factors that I’ll tell you about in just a moment. But, here’s where it gets interesting.
This is the same kind of crash that made history almost 12 years ago to the day you should be watching this video. I’m making this video on Thursday, it’s being released on Friday. May 6, 2010, was when we had the infamous flash crash here in the U.S. Now, that crash sent the Dow Jones down by 1,000 points in just 10 minutes. It wiped out about 9% of the market. That was $1 trillion in equity value gone before anyone knew what hit them.
Maybe, with the exception of 1987, up until that point, no one had ever really seen anything like that prior to 2010. Once again, in a matter of seconds, the stage was set for the market to just completely unravel, over the course of minutes, really. These kinds of moves, they’re too fast for human traders to respond to, let alone the market’s circuit breakers, that are supposed to slow down these steep sell-offs, couldn’t really do anything to stop the bleeding.
Flash Crashes Are New, Unpredictable and Rare
We call them flash crashes because of their unprecedented speed. And thankfully, these events, these flash crashes, they’re relatively rare. There’s just a lot of different market forces coming together. You’ve got artificial intelligence, you’ve had high frequency trading in place for some time now. As we saw earlier, even a human error, a fat-finger trade, can be a trigger. What makes those unique, those flash crashes, they unfolded in minutes. They happen in mere minutes. Since they began, what I’ve noticed, we’ve also seen more steep, what I’ll call waterfall declines, that can take the indexes down very dramatically, in just a matter of days. In other words, we’re investing in, and what we’re seeing right now, just in the past decade, is just an increasingly inhuman, an increasingly inhospitable, really, marketplace.
Let me give you a couple of examples of these waterfall declines that I’m talking about. Take a look at 2011, for example:
That was an 18% decline that took place in only about two weeks. 2018 was a 12% decline that happened over just 11 days:
Then, of course, go back to the start of the pandemic. 2020’s bear market plunge was 35%, that occurred in only one month:
That’s what I want to talk about today. I want to talk about some of the factors I’m monitoring, three specific conditions in place today that have me concerned that we could see, whether it’s another flash crash here in the U.S., or that maybe another waterfall decline is lurking right around the corner. Let’s get into what those three conditions are here.
Conditions in Place for a Repeat?
Alright, condition No. 1.
Major selling has already been taking place since last year. You’re only now seeing that reflected in the big indexes, like the S&P 500. As we know, the S&P 500 is down 13% through April, to start the year. That is, by the way, its worst start since 1939. Look at what’s already been taking place with stocks in the Nasdaq. Here’s a chart:
The bottom panel shows you a couple of lines on here. This blue line shows how many stocks, once again, in the Nasdaq, have seen a draw down to 50%. You can see that number is at 45%. Forty-five percent of stocks in the Nasdaq have been cut in half. They are down by 50%. You can also see that 20% of stocks have plunged by 75%. Look at this, look at where the selling started at on here. Those lines, they started to increase back at the start of 2021. When you see this kind of sustained selling, really deep into the red for the stock market, it means the market’s foundation is growing weaker and weaker, at least is what you’re seeing with these current prices.
Oversold Stocks = Risk of Waterfall Declines
Now, what you’re seeing is that selling has come from names we’ve seen this during earnings season. Netflix getting pummeled, you’ve seen that with Amazon, Maita. These are the names, actually, that were propping up the markets last year, despite all the selling elsewhere that was occurring underneath the hood. When stocks are sold this deep, it’s like a bedrock of institutional money that is going away. That makes the stock market far more susceptible to those waterfall declines we were talking about earlier. In fact, I think that’s a part of the reason why the Dow crashed 900 points back on Friday, last week.
Alright, condition No. 2: volatility. Volatility is another factor, another defining factor, when it comes to these waterfall declines and these flash crashes. Right now, I think there’s more volatility in the market than what most investors and traders realize. When most investors think of volatility, a lot of times we talk about the VIX Index. The VIX Index is often referred to as Wall Street’s fear gauge, because it tends to rise at volatility. It goes up when the markets are going down, and vice versa. Other measures of volatility, they paint a different picture. I like to compare something called the average true range to the VIX, and here’s why.
With VIX, you may not know this, but with VIX, this is a measure of what’s called implied volatility. It’s an estimate of where traders think volatility is going over the next 30 days. With average true range, over a certain look back period, it tells you what volatility is already doing. It’s not an estimate of what’s going to happen, it’s a look, instead, at what’s already happening. Average true range is running at the highest level since that March, 2020, crash.
Now, here’s my concern. If VIX follows suit, if we see the VIX index start to increase to similar levels, taking out similar levels historically, it could create this feedback loop that leads to that waterfall decline-type event. That’s because of the sheer number of institutional investors that now use volatility strategies. There are risk parity funds, there are funds that use volatility targeting. Simply put, when VIX increases, when volatility increases, they will sell to reduce their stock market exposure.
That selling pushes VIX higher still, so they sell more. On and on, it’s this feedback loop. Once again, this is not just a conscious decision on their part. In most cases, it’s largely driven by algorithmic trading. It would automatically happen, there’s an automatic trigger. The machines create what I call a volatility trigger.
Finally, condition No. 3, a chart pattern has shown up. A chart pattern I did not want to see show up has shown up here, for the S&P 500 Index. It’s a unique, highly specific chart pattern that last turned up, guess when? Twelve years ago. Twelve years ago, just before 2010’s flash crash. It’s a pattern called a diamond top, and I see this often occur at or near a market peak, just prior to a correction. Here’s 2010’s scenario, how it played out:
You can see the pattern is formed. Firstly, you have this expanding pattern, marked by higher highs and lower lows, and then, a contraction in the pattern. It’s lower highs and lower lows. Then, you see the breakdown, and you can see in 2010, how that occurred just prior to the flash crash, when it happened back then. And then, here’s 2022’s pattern:
In 2022, we see a similar pattern set up. Since about mid-April, we’ve started to break down from that pattern. Those are the three conditions, and I have just one other thought here. In action movies like The Matrix or the Terminator series, the plot is that mankind is overthrown by artificial intelligence.
The robots get smarter, and they take out mankind. Now, the robots in these flicks, they always use brute force. You see shootouts, you see Kung Fu, but, as we see here in the real world, they are far more subtle about their takeover. Our technology, this information age, it’s empowered a whole new generation of traders, of algorithms, that can think and act faster than what any human trader can. This creates a whole new kind of challenge for the average investor, and we must evolve. We must adapt, so that we can continue to thrive in, once again, this increasingly technology-driven market.
Fortunately, there are tools out there, things that we can monitor for what could happen next. That’s what I’m bringing up today. Stay one step ahead, keeping an eye on these chart pattern breakdowns. Keeping an eye on volatility levels, and discrepancies between realized and implied volatility, and how tracking how the average stock is performing that participation under the hood can help you stay one step ahead of the next flash crash, or the next waterfall decline, whatever it may be.
Alright, that’s it. This has been Clint Lee, from The Bauman Letter and Big Picture, Big Profits. Just a quick reminder, please give me a like, please subscribe to our channel and once again, I would love to hear your comments below on this very topic. Thanks!