Protecting Yourself from a Flash Crash

November 4, 2016


By Nima, Director of Client Relationships

A flash crash is a market scenario characterized by a sudden and steep fall in asset prices, often due to unforeseen and sometimes unexplainable forces. While these are considered rare “black swan” events, the most recent sterling flash crash serves as a reminder that you should stay vigilant and protect your account from getting wiped out from these.

GBP Flash Crash

A couple of weeks back, the British pound plummeted by thousands of pips to record lows against its forex counterparts on what was seen as a combination of market factors. Many believe that the drop was triggered by French President Hollande’s remarks on making Brexit negotiations tough for the United Kingdom, asserting that leaving the European Union comes at a price.

News-based algorithmic trading systems likely picked up on these keywords suggesting more losses for the British pound, creating sell orders that may have been tracked by other black box systems as well. Some say that a “fat-finger” trade or a position that had one too many zeroes in it by mistake may have also caught the attention of traders and mechanical systems, causing a flurry of sell orders. And with these catalysts occurring during the London and New York session overlap, liquidity was thin enough for these orders to move the markets in a sharp direction, leading market makers to scramble to adjust prices in order to match those positions.

As a result, the pound fell 6% against the dollar in just two minutes, bringing it down to its lowest levels since May 1985. The British currency just as quickly recovered most of its value in the succeeding minutes but was unable to climb back to its pre-flash crash levels.

2015 SNB Announcement

Another forex market event that was seen as a flash crash is the Swiss National Bank’s announcement back in 2015, which triggered massive moves for the franc and the euro. Prior to this, the SNB has been known for intervening in the currency market in order to keep its currency artificially weak, thereby maintaining an advantage in international trade. In particular, the SNB had imposed a EURCHF peg at 1.2000, adding euros to its reserves to defend the floor even while the European Central Bank had been easing monetary policy with rate cuts and bond purchases.

But in January last year, the SNB abruptly decided to scrap the peg altogether, without even providing any warning to the markets. The central bank didn’t even have a monetary policy announcement scheduled then! Because of that, EURCHF was in a free fall from 1.2000 to the .9700 area, sending shockwaves to other European currencies as well.

Compared to the pound’s flash crash this year, the 2015 SNB shocker was much more damaging to trading accounts and even for brokers. The announcement was made during another low-liquidity point in the day, causing several positions get stopped out and accounts to get wiped off overnight. Some clients were even left with negative account balances and brokers had a difficult time collecting on those losses, leading some to close shop or to secure bailout funds from other financial firms.

2010 Flash Crash

Perhaps the most memorable flash crash for many traders is the one that occurred in May 6, 2010 wherein US equity indices plunged then recovered rapidly. The Dow Jones Industrial Average chalked up its biggest intraday drop of nearly a thousand points or 9% within minutes before rebounding to make the second-largest intraday point swing of 1,010.14 points.

The magnitude of the crash was approximately a trillion US dollars, triggered by a $4.1 billion trade on the New York Stock Exchange that caused unprecedented fluctuations and a surge in financial trading volume. Similar to the pound and franc flash crash, this also occurred against a backdrop of thin liquidity and high volatility, according to a CFTC report on the incident.

The report went on to say that a large fund initiated a sell order of 75,000 E-mini S&P contracts as a hedge to an existing equity position. High-frequency trading systems picked up on this unusually large position and also started selling these futures positions aggressively, and the lack of sufficient market demand from buyers prompted these systems to quickly buy and resell contracts to one another in what is being called a “hot potato effect.”

Lessons Learned

What’s common among these recent flash crash incidents is that they occurred during periods of thin liquidity, which then opens up the possibility of seeing more volatility than usual whether or not there were any fundamental catalysts involved. Apart from that, mechanical systems such as HFT algorithms are seen to have exacerbated the effect, resulting to larger market moves in a very short period of time.

While these incidents are rare, they can sneak up to surprise the markets anytime so it’s best to ensure that your trading accounts are protected from huge losses that could result from these events. One way to go about this is to consider having stop losses in place for your positions, particularly those that you plan on keeping open overnight. This way, you may set your maximum trading loss on the position and can get out of the trade even if price swings wildly against your trade.

Another possible way to protect yourself might be to trade with a broker that guarantees against negative account balances so that you won’t wind up with a gaping hole of debt in the worst case scenario. Also, it helps to have a strong understanding of margin and leverage to make sure that you’re not exposing your account to more risk than you can handle.

Brokers and even financial regulators have learned their lessons from these flash crash incidents themselves, strengthening regulation to monitor large positions and imposing stricter requirements for exchange-traded funds in order to protect market players. Officials even put “circuit breakers” in place for equity indices to halt trading if any stock rises or falls by more than 10% in a five-minute period.

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