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Flash Crashes

In: Business and Management

Submitted By Frankeea
Words 1822
Pages 8
Why do flash crashes happen
In May 2010, the stock market lost and regained almost 10% of its value within minutes. This behavior suggests that the markets are unhealthy. Markets are generally considered to accurately determine the underlying value of assets in the real world. During a flash crash, the price is determined by the dynamics of the market rather than by real-world value.
Fig. 1

Fig. 2

Fig. 3

Flash crashes can be understood by looking at how trades occur in the market. Figure 1 shows the standing buy and sell orders ("limit orders") at a particular time in the market. Each order is shown at the price it is offered. The shape of the buy order curve shows that at lower prices, traders want to buy more shares. But there are no orders at very low prices because nobody expects the price to drop that far. The reverse is true for sell orders: the number of orders increases as we go to higher prices and then disappears at still higher prices. In Figure 1, no trading would occur because there is no price with both a buy order and a sell order. Trades happen when someone enters an order to buy or sell at the current market price (a "market order").

Figure 2 shows the order book after a market sell order. The seller's shares go to the traders with the highest-priced standing buy orders. The executed buy orders disappear from the order book. The price drops to where the trade was executed. This is how selling a stock decreases its price.

From this we can understand how a flash crash happens: when a very large market sell order is placed, it can execute against all of the limit buy orders, which makes the buy order curve disappear and the price plunge, as shown in Figure 3. This is what happened in the May 2010 flash crash .

Even if a single order is not quite large enough to deplete all the buy orders, traders might panic if the price of a…...

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