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Market Analysis – Can the Flash Crash happen again and can it be predicted?

Market Analysis – Can the Flash Crash happen again and can it be predicted?

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Published by Hedgefund Live
Hedge Fund LIVE trader Eric Kelly analyzes the possibility of another Flash Crash.
Hedge Fund LIVE trader Eric Kelly analyzes the possibility of another Flash Crash.

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Published by: Hedgefund Live on Feb 28, 2011
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05/12/2014

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Market Analysis – Can the Flash Crash happen again and can it be predicted?HedgeFundLIVE.com –The Flash Crash (FC), May 6th 2010, is the biggest one-day point drop in the history of the DJIA (998.5 points) and the third highest volume  day ever (but oneof the most illiquid). Studies conducted by the SEC and other private groups have shown the FC was caused by a multitude of factors, which can be understood simply as a snowball effect. Factors, such as liquidity consumption, high-frequencytrading, normal market action, and a lack of retail trading all played into thehistoric move. Contrary to popular believe the FC was not caused by a “fat finger”or one single High-Frequency Trading firm (HFT). This article will attempt to clarify the confusion, discuss the use of the VIX as a hedge, and how another FC can potentially fit into our market conditions.In a study conducted by David Easley (Cornell), Marcos M. Lopez de Prado (TudorInvestments), and Maureen O’Hara (Cornell), some of the major causes are identified (link to the study Study). What they found is that the ratio of informed trading volume to total volume had been elevated for days prior to the FC. The metricthey used to measure this, also developed by the group, is called the VPIN or Volume-Synchronized Probability of Informed Trading. There are of a lot of ways to define the VPIN, here’s the way I find easiest: It is a ratio; the numerator isthe absolute difference between buy-volume and sell-volume which is basically ameasure of toxicity for maker makers*; the denominator is the total trading volume. The intriguing part about the VPIN is that it displayed elevated levels fora couple days before the FC occurred and ultimately peaking on May 6th, which means its predictive not reactive. When the VPIN is increasing, one to several things may be happening, here are a few (these reasons are FC specific):-Total trading volume may be falling; this decreases the denominator and increases the ratio.-Retail investors are trading less. This increases the numerator, because the population of active traders in the market then contains a higher percentage of informed-traders overall, such as hedge fund traders. Retail investor trading decreased due to the market crash a year earlier and the economic downtown. This will also decrease the denominator, thus elevating the ratio dually fast and consuming liquidity.-HFTs, which actually act as market makers due to their low profit targets and extremely high number of actual trades, leave the market because of already existing liquidity problems. When this happens the HFTs consume liquidity that is already at low levels. This decreases the numerator but drastically decreases the denominator as well because they represent roughly 70% of total trading volume inUS equity markets.-Market makers leave the market, caused by a rise in toxicity*, this absolutelydecreases the denomitor.The VPIN displayed a rise due to all these factors and more. Although May 6th was one of the highest volume days ever, the actual liquidity was extremely low. This low liquidity (measured by the VPIN) can have a downward spiraling effect. The Flash Crash can be understood to be caused by low liquidity in an already nervous market, which results with investors essentially being hand-cuffed to cascading stocks. The VPIN, hypothetically could have predicted the FC and given regulators time to take precaution or at least give market makers a chance to be proactive.Grown-up "Kevin McCalister" not having much fun anymore.

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