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May 6'th 2010 Flash Crash Analysis
Final Conclusion

Publication Date: October 14, 2010

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Our analysis of the Waddell & Reed e-Mini trades led us to an unexpected break-through. By process of elimination, and with the SEC report for context, we finally have a crystal clear understanding what caused the May 6, 2010 flash crash.

First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.

The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could. The sale was so furious, it would often clear out the entire 10 levels of depth before the offer price could adjust downward. As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.

Because of arbitration, when the e-Mini changes price with high volume, many ETFs are repriced (quotes updated, trades executed). The component stocks of ETFs are also repriced, along with many indexes. And finally, all the option chains for the ETFs, their components and indexes are also repriced. The entire system simply cannot absorb the impact of a sudden move in the e-Mini on high volume. A sale (or purchase) of 2,000+ contracts which rips through one-side of the depth of book in 50-100 milliseconds, will immediately overload many systems. The impact reverberates for a much longer period of time than the sell (or buy) event itself.

The first large e-Mini sale slammed the market at approximately 14:42:44.075, which caused an explosion of quotes and trades in ETFs, equities, indexes and options -- all occurring about 20 milliseconds later (about the time it takes information to travel from Chicago to New York). This surge in activity almost immediately saturated or slowed down every system that processes this information; some more than others. Two more sell events began just 4 seconds later (14:42:48:250 and 14:42:50:475), which was not enough time for many systems to recover from the shock of the first event. This was the beginning of the freak sell-off which became known as the flash crash.

In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive,  low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear.

The chart above shows the high and low prices of the eMini for each 100ms interval (light blue). The green line with green dots and numbers shows the total number of Waddell & Reed contracts sold up to that point. Red price bars indicate the range of prices of W&R trade executions during that period. The light blue bars in the bottom section indicate the volume of eMini contracts traded in that interval. The scale for the volume is below the scale of the prices. Finally, the light green line in the chart above, shows the total number of equity trades in all equities during that 100ms interval -- there is no scale for this line -- it is shown to illustrate the correlation with the eMini contract volume traded during the same interval.

The chart below is the same as the chart above, except in place of the trade counts (light green above), it shows the quote counts for all equities during each interval (light gray).


Publication Date: October 14, 2010

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