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The Flash Crash (FC), May 6th 2010, is the biggest one-day point drop in the history of the DJIA (998.5 points) and the third highest volume day ever (but one of the most illiquid). Studies conducted by the SEC and other private groups have shown the FC was caused by a multitude of factors, which can be understood simply as a snowball effect. Factors, such as liquidity consumption, high-frequency trading, normal market action, and a lack of retail trading all played into the historic move. Contrary to popular believe the FC was not caused by a “fat finger” or one single High-Frequency Trading firm (HFT). This article will attempt to clarify the confusion, discuss the use of the VIX as a hedge, and how another FC can potentially fit into our market conditions.
In a study conducted by David Easley (Cornell), Marcos M. Lopez de Prado (Tudor Investments), and Maureen O’Hara (Cornell), some of the major causes are identified (link to the study Study). What they found is that the ratio of informed trading volume to total volume had been elevated for days prior to the FC. The metric they used to measure this, also developed by the group, is called the VPIN or Volume-Synchronized Probability of Informed Trading. There are of a lot of ways to define the VPIN, here’s the way I find easiest: It is a ratio; the numerator is the absolute difference between buy-volume and sell-volume which is basically a measure of toxicity for maker makers*; the denominator is the total trading volume. The intriguing part about the VPIN is that it displayed elevated levels for a couple days before the FC occurred and ultimately peaking on May 6th, which means its predictive not reactive. When the VPIN is increasing, one to several things may be happening, here are a few (these reasons are FC specific):
-Total trading volume may be falling; this decreases the denominator and increases the ratio.
-Retail investors are trading less. This increases the numerator, because the population of active traders in the market then contains a higher percentage of informed-traders overall, such as hedge fund traders. Retail investor trading decreased due to the market crash a year earlier and the economic downtown. This will also decrease the denominator, thus elevating the ratio dually fast and consuming liquidity.
-HFTs, which actually act as market makers due to their low profit targets and extremely high number of actual trades, leave the market because of already existing liquidity problems. When this happens the HFTs consume liquidity that is already at low levels. This decreases the numerator but drastically decreases the denominator as well because they represent roughly 70% of total trading volume in US equity markets.
-Market makers leave the market, caused by a rise in toxicity*, this absolutely decreases the denomitor.
The VPIN displayed a rise due to all these factors and more. Although May 6th was one of the highest volume days ever, the actual liquidity was extremely low. This low liquidity (measured by the VPIN) can have a downward spiraling effect. The Flash Crash can be understood to be caused by low liquidity in an already nervous market, which results with investors essentially being hand-cuffed to cascading stocks. The VPIN, hypothetically could have predicted the FC and given regulators time to take precaution or at least give market makers a chance to be proactive.
Grown-up "Kevin McCalister" during the first #Flash #Crash
Can the VIX safeguard your portfolio from another Flash Crash? Unfortunately, the answer is no. The VIX, which is based on the expected 30-day volatility of the S&P 500 options, is only able to be reactionary to a crash, not predictive. The VIX is mostly misunderstood by the people looking at it, it is important to note that it is reliant on humans due to its use of option implied volatility, not directly of the S+P500. The VIX does not always rise due to panic, it can rise for many reasons, this is why it does not perfectly correlate with the S+P 500. Specifically, the index is based on volatility and that is what the index is used to hedge against, the FC was caused by low liquidity. Obviously these are two different market components.
So the questions are, can another Flash Crash happen and what may cause it. The answer to the first half is simply and sadly, Yes. The answer to the second half of the question is that commodities, economic unrest, political unrest and many more factors could trigger it, particularly oil. Commodities which have grown in the retail investing spotlight, can potentially take small amounts of volume away from equities markets. If you are familiar with the term risk aversion, you understand that when people want to hedge their overall investment risk they leave equities and turn to commodities such as the US Dollar, gold, silver, etc. Economic unrest could trigger similar risk aversion strategies, with volume consumption and asset flights away from equities. It is possible the problems in the Middle East (political problems) could initiate huge increases in the price of oil, which will adversely effect the equity market. When oil prices rise investor-spending rises which causes less savings, i.e. spending more on gas or groceries instead of buying their favorite company’s stock. Oil price increases also cause companies to have higher expenses, which lowers fundamental worth in terms of investing, this can lead to lower stock valuations, which can lead to lower trading volume. Just because oil is rising, doesn’t mean everything is going down, some investors who are wise enough will hedge their lives by directly investing in it; this will also create a lower liquidity situation when people take the money they had in Ford and buy oil futures with it.
It should be understood that these reasons mentioned in the preceding paragraph will most likely not cause an FC on their own. They simply create an environment in which, another crash could occur. The Flash Crash is somewhat comparable to a perfect storm, a lot of bad elements that combine to create something much larger and much more dangerous.
Again the point of this article was to attempt to clear some confusion about the Flash Crash and discuss the current market we are trading.
*Toxicity: for market makers is basically they’re expected loss from transactions.
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