I have been thinking about writing a detailed post on the Flash Crash of 2010. Last week when British Pound crashed 1200 points in just 2 minutes, it again brought home fact that flash crashes are becoming a regular feature. As a trader we should be aware of the possibility of a flash crash happening anytime. This is what happens when a flash crash takes place. Price suddenly plunges 600-1000 points in a matter of 1-2 minutes. Then recovery takes place and price rebounds and recovers 50% of the loss. We should understand how these flash crash develop and how we can mitigate our losses when this crash happens. This means we should include this outlier event or a black swan event with market moving against our trade 1000 points in just a few minutes in our risk management system.
Stop Loss Don’t Work During A Flash Crash
Most of the time when the market crashes stop losses don’t work and the whole bid/ask system freezes until situation becomes clear. When the thing situation returns to normal, you can find your trade with a huge loss with the stop loss haven’t been triggered during the very fast movement of the market. So how we do face such a situation in which market moves against you 1000+ pips in just a few minutes? The most sensible way way to deal with these flash crashes is always keep risk 1% at all times. This ensure will ensure that our account doesn’t get blown easily. Did you read the previous post on How I Made $2,000,000 In The Stock Market? This is the story of an amateur trader Nicholas Darvas who finally managed to make $2M in the stock market.
Anatomy of Flash Crash May 6th 2010
The purpose of this post is to analyze in depth what happened during Flash Crash 2010. Pound Flash Crash happened last week and it may take regulatory authorities a few months or even a few years to dig out what had happened on that day. Flash Crash 2010 was extensively investigated by US regulatory authorities. You will be surprised to find that Flash Crash 2010 was caused by a home based trader Navinder Singh Saro. Navinder Singh Saro was living with his parents outside London. He would trade daily from the basement from his parent’s home. Primarily he was active in the Emini S&P 500 futures market.
This is Navinder Singh Saro trading strategy: he will sell without getting his orders filled. How did he achieve selling contracts without the sell orders getting filled? He would sell a few points above or what you call ticks above the best offer and keep updating the orders so that even if the market moved up, his sell orders wont get filled. Doing this manually is not easy. It requires constantly watching the market. So he coded his trading strategy into a robot. This is what he would do. Place big sell orders using his robot. The robot would make sure those sell orders are are updated and always a few ticks above the best offer. When other traders would see those big sell orders they would take it as a signal to sell. This would drive down price. When price would go down. Navinder Singh Saro would close his robot and buy at that lower price. When other traders would see the big sell order gone, they would starting buying thinking the market is going up. This would drive the market up.
This is how Navinder Singh Saro was trading Emini S&P 500 futures. This trading strategy is known as Spoofing and it always work. But it is illegal. If Navinder Singh was spoofing, it should have been the duty of his broker to make sure he get a warning a few times and if he persists his account gets suspended. But no one took care. So daily Navinder Singh Saro would trade using his spoofing robot placing huge sell orders and driving down price. When price would go down he would switch off the robot and buy as said above. But on May 6th 2010, things worked out too well for him.
On May 6th 2010, Navinder Singh sold 62,077 Emini S&P 500 futures contract The notional value of these futures contracts were USD 3.5 Billion. Navinder Singh made a total profit of USD 879,018 on May 6th 2010. This coupled with a low buying interest shown by other investors just crashed the market. Now spoofing is illegal as said above. Navinder Singh has been using his spoofing strategy on daily basis and regulatory authorities kept sleeping.
The flash crash of 2010, opened the eyes of regulatory authorities to Navinder Singh spoofing. All this is well documented. You can read the full pdf report issued by SEC on its investigation on May 6th 2010 Flash Crash. It was one large sell order that panicked other traders and this caused the market to crash.When price started falling rapidly, everything freezed. For seconds there was no market. Everything had freezed out. Interesting at the time of flash crash Navinder Singh spoofing robot was switched off. SEC Report insists that he is responsible for the flash Crash even if his spoofing robot was switched off as his big sell orders were the trigger that had panicked the market. As said above, his spoofing activity should have been detected by the broker much earlier and his trading rights suspended.
Documentaries on Quantitative Trading
Now I have read claims by other traders that they had predicted 2010 Flash Crash months ahead. Talk about using astrology in trading? WD GANN was a legendary trader who used astrology in his trading strategies. In this post I have tried to take a look at his trading strategies. Now if you are interested, you can watch this Money & Speed Documentary below in which traders talk about what happened during that flash crash. Watching these videos can give you a good idea how algorithmic trading works. Watch this documentary on Money and Speed. This is a well made highly informative documentary that you should watch.
You should be knowing what is quantitative trading. Traders who use quantitative trading strategies are known as Quants. Watch this documentary on Quants who frequently get blamed for causing these flash crashes. This is another well made documentary that you should watch. Now back to the question that we had posed at the very start of this post. How to deal with these sudden flash crashes? You should have read the answer. Keep risk as low as possible because when stop loss doesn’t work, only low risk can save you. Good thing. After 2010, no new flash crash has taken place in the US markets. US regulatory authorities have taken precautionary steps to avoid these flash crashes.
This is the story of Navinder Singh Sarao. We will call him Nav. He came from a working class background. He joined a trading prop firm and started trading. He never bothered to use a stop loss in his trading strategy. Of course using a stop loss is an inconvenience but we do it because we want to limit our losses. Nav never used a stop loss. He made money. The prop firm owner was happy but always worried that he left the trade open at night without any stop loss when he left for home. Anything could happen during the night. His big break came when one day he observed DAX bouncing off from a support level again and again. This gave him the trade order and he opened a big short position above that level anticipating DAX to fall heavily before he left for home in the night. Next morning when he came he was elated to see $10K profit in his account. DAX had fallen 70 points during the night. Nav repeated this trade daily for the next two weeks before going home every night. Next morning he would be winning big profits most of the time. He increased the lot size and made a USD 1 million profit. The money that he made was due the a French Trader who had opened a large position on DAX for his bank. He was propping his position by opening more lots everynight as market was going down and he didn’t want to lose his job. Later on the French bank found out what was happening. The trader went to jail and was ordered by the court to payback USD 7.2 billion to the bank that he had lost.
After making a million dollars Nav started opening big position comprising 100s of lots. He thought of developing a robot that would trade eminis. The idea was simple the robot will open a large position. When price will come close, the robot will close the position before it gets filled and open again at different level. So what the robot was doing was spoofing. Open big limit order and fool the other traders that his is an important support or resistance level. His robot was a success. He was infact making the market move with this big orders. One day he made USD 800K profit. A few times he got warning from the exchange for his illegal trading activity. But he ignored it.Then in 2010 one day market crashed and S&P 500 index hundreds of points that day. He made USD 800K that day as mentioned before.
Market crash was sudden and wiped out around a trillion dollars from the US Financial Markets. An investigation started. First a few hedge funds got accused. Later on someone whose name we never disclosed did a forensic of the exchange data and he point out a trader who was placing huge limit orders and cancelling them without letting them get filled. This man was Nav. Suddenly one day FBI alongwith the local British Police knocked on his home and arrested him. His parents had no idea what he has been doing. He had made more USD 50 milion by them but he was living a frugal life and never told his mother father or brother how rich he had become. Instead he hired a few persons as investment advisors and invested his money with a Mexican with a Russian wife who was running a fund in Switzerland. Garcia was a crook. He took all his money and vanished.