Flash crashes and liquidity gaps

What you will learn

• What a flash crash and a liquidity gap are, and the feedback loop that drives them
• What official reports found about the US flash crash of 2010 and the sterling flash event of 2016
• How clustered stop orders sweep a thin order book
• How to estimate your real loss in R when your stop fills inside a liquidity gap

Explanation

A liquidity gap is a price zone where the order book holds little or no volume, so a market order jumps straight through it. A flash crash is an extreme, very fast price fall, often within minutes, followed by a partial or full recovery. Overnight price gaps and why they can exceed a stop were covered in the risk-management course; here we look at gaps that open during trading.

The feedback loop

1. A large or urgent sell flow hits the market.
2. Liquidity providers see unusual risk and widen spreads or withdraw quotes, so depth falls.
3. Prices fall further and trigger stop orders and automatic margin liquidations, which become new market sell orders.
4. These orders meet an even thinner book, and the loop repeats until buyers return or a safety mechanism pauses trading.

Three documented examples

• US stocks, 6 May 2010: the Dow Jones Industrial Average fell nearly 1,000 points in less than half an hour and then recovered much of the drop. The joint report of the SEC (Securities and Exchange Commission) and the CFTC (Commodity Futures Trading Commission) found that an automated program sold about 75,000 E-mini S&P 500 futures contracts, worth about $4.1 billion, in roughly 20 minutes into an already stressed market. Some shares briefly traded at absurd prices, and exchanges later cancelled many trades as clearly erroneous. Single-stock circuit breakers were introduced afterwards.
• Swiss franc, 15 January 2015: the Swiss National Bank removed its minimum rate of 1.20 francs per euro. EUR/CHF fell far below 1.00 within minutes, liquidity disappeared, and many stop orders were filled far from their stop levels. Some retail clients lost more than their deposits; negative balance protection for CFDs, covered in the derivatives course, was introduced in the EU later.
• Sterling, 7 October 2016: according to the BIS Markets Committee report, the pound fell by around 9% against the dollar in early Asian trading and quickly recovered much of it. The report found no single cause: the illiquid time of day, options-related hedging, stop-loss orders and some algorithms combined.

What this means for you

• A stop-market order guarantees an exit, not a price. In a gap it fills at the next available bid.
• A stop-limit order protects the price but may not fill at all, leaving you in a falling position.
• Stops placed at obvious levels (round numbers, just below a recent low) are often clustered, so many trigger at once.
• Thin times (night sessions, holidays, the first minutes of trading) raise gap risk.

Worked example

Hypothetical example: You bought 200 shares at €102.00 with a stop-market order to sell at €97.00. Planned risk: (€102.00 − €97.00) × 200 = €1,000 = 1R (R is your planned risk per trade). Bad news hits during trading. When the price touches €97.00, the bid side has thinned to:

Other traders' stops at €97.00 total 700 shares and reached the market first (they were entered earlier).

1. The other 700 shares take 200 at €96.80, 300 at €96.00 and 200 at €94.50.
2. Your 200 shares fill at the remaining €94.50 level: 200 × €94.50 = €18,900.
3. Your loss: (€102.00 − €94.50) × 200 = €1,500 = 1.5R.
4. Gap scenario: if the share instead opened the next day at €90.00, the stop-market fills near €90.00: (€102.00 − €90.00) × 200 = €2,400 = 2.4R.
5. With a stop-limit at €97.00 / limit €96.00 in the gap scenario, nothing fills. You still hold 200 shares worth €18,000, an open loss of €2,400 that can grow.

Excluded: fees, taxes, and the exact trigger order, which depends on the venue's rules.

Common mistake

Practice activity

You are long 400 shares bought at €50.00, with a stop-market at €47.00. When the stop triggers, the bids are €46.90 × 300, €46.50 × 500, €45.80 × 800. Other stops of 600 shares execute before yours. (a) What is your planned risk? (b) What is your average exit price? (c) What is your real loss in euros and in R?

Key takeaways

• Flash crashes are driven by a loop of selling, withdrawn liquidity and triggered stops.
• Official reports on 2010 and 2016 found combinations of causes, with thin liquidity at the centre.
• Stop-market orders exit but can fill far below the stop; stop-limit orders may not fill at all.
• Plan for losses larger than 1R and avoid placing stops exactly where everyone else does.

Next step

Next, you will learn to read time and sales and volume profiles to see where volume actually traded.