Flash Crashes – Can Options Help Avoid Damage?
A recent question at the SaferTrader.com FORUM has prompted this closer look at “Flash Crashes.” Are we indeed powerless in the face of a flash crash, or are there defenses?
Recognizing a Flash Crash: Hindsight Required
It’s not just the market dropping sharply. A sudden hard fall in an individual stock, ETF, or the market as a whole can occur for a host of reasons. No matter the cause, a sharp drop can incentivize many investors to rush to exit their positions at the same time and/or pile on with fresh short sales… further exacerbating the decline.
For it to be a “flash crash” though, the market must fall hard, do it quickly, and then quickly recover.
After the fact, unhappy investors can find that they have abandoned perfectly viable positions – and more importantly have lost money – because the market lied.
The most famous, recent flash crash occurred on May 6, 2010 just after 2:30 pm, EST. Studies of this flash crash abound, including those by the SEC and CFTC.
They reported several working hypotheses but no single cause has been officially identified to this day. However, the first “explanation” was that a mistyped order caused the collapse (that hypothesis was later abandoned).
In the aftermath of the 2010 flash crash, 21,000 trades were “cancelled” by the exchanges because of orders that were filled at “unexpectedly low” prices.
The often slow and deliberate SEC moved quickly to establish new “circuit- breaker” rules that called for trading to cease when any stock price changed by more than 10% in a 5 minute period.
Possible Causes For Flash Crashes
Exceptionally large order
When a very, very large sell order “hits the tape,” it uses up the resting buy offers quickly. New bids fall sharply as the selling pressure from the initial sell order multiplies. Stop loss orders are triggered and panicked “longs” rush to the exits just when potential buying interest is drying up or has already done so.
Because many market sophisticates track option activity (e.g. put/call ratios) as important market indicators, unusual option activity – especially in the “put” options – can trigger a flash crash.
Legitimate headline development – An unexpected or potentially disruptive news event occurs. Market-wide examples include geopolitical upheaval (war scare or reality) and release of economic data. Company-specific headlines might involve earnings surprises, ominous announcement that “another announcement” is coming, news released about a pending or decided regulatory action, etc.
Erroneous headline development – Mistakes happen. The offending word in the report was a typo, the prime minister was not hurt after all, etc.
Fraudulent headline development – This is a very real phenomenon that owes its success in agitating markets to our increasingly effective methods of rapidly and widely disseminating information…and misinformation. The world of social media and online chat rooms are perfect breeding grounds for the unethical to create and/or spread false rumors meant to help drive a market in a direction helpful to the perpetrator’s position – if only momentarily.
High Frequency (Automated) Trading – is often blamed for flash crashes and the charge can be legitimate. The exchanges and the Feds continuously and nervously probe this high tech approach to trading. Very fast computers churn out mathematical algorithms to indicate the likely direction of a market 2 nano-seconds from now… and place an order to trade the results of said calculations in one nanosecond.
In recent years, very large market participants – funds and even countries – account for a large proportion of total trading volume. These big entities have big computers, often reaching the same conclusions, and resulting in a “herd” selling spasm when the software signals downward movement ahead.
Defending Against Flash Crashes
The reality is inescapable: during the initial seconds and minutes of a sudden swoon in the market as a whole or in a specific equity, there is no way to know if the decline is “justified,” or if it is a flash crash and will therefore quickly return to pre-decline levels.
The distinction is critical. If it’s a meaningless blip in the trend you want to maintain your position. If it’s a real turning point that can lead to a major decline of uncertain duration, you indeed want to join the crowd and “get out while the getting’s good.”
Market participants are not entirely helpless in the face of this uncertainty.
SEC and CFTC rules changes/Circuit Breakers – As mentioned earlier, the market regulatory bodies are definitely interested in minimizing scary market swoons. The prior years’ “uptick rule,” that required an uptick in price compared to the previous trade before one could sell short, was an effort to prevent cascading downdrafts in price.
The so-called circuit breaker rules are another attempt to blunt the likelihood or extent of a flash crash. The idea is to give cooler heads a chance to think things out, confirm whether or not the triggering development was “real,” and decide that maybe the reduced price represents a fine buying opportunity,
Pre-trade flash crash avoidance considerations
While we can’t eliminate the possibility of being bitten by a flash crash, there are some actions we can take before-the-fact to reduce the probability of our being caught in such a crash.
If we are trading individual stocks, we can favor stocks that have considerable liquidity, i.e. significant investor participation and trading volume. These may be less likely to be dramatically affected by a large sell order and may offer a large pool of investors on sidelines looking to snatch up the stock during a “dip.”
If one owns actual stocks, another up-front risk limiting tactic is to use option puts rather than a stop loss order on the security itself, to define and limit risk. This is discussed in more detail in the SaferTrader “white paper” Option Stop Loss Orders? There Are Often Better Choices
Basically, buying an appropriate put option will limit risk to a pre-defined amount like a stop loss order (even better, since there is no slippage), but will also enable the stock investor to ride out what turns out to be a flash crash.
In fact, because of their flexibility, option spreads are particularly well-suited for avoiding flash crash losses by limiting the position risk to the spread’s built-in predetermined amount, while not requiring selling out a position in a mistaken market exit.
There are professional investors who, subsequent to the pain of the October 6 flash crash, now use only put option spreads when establishing bullish positions. This limits risk to a known amount and allows riding out an adverse move in the underlying that might be a flash crash. They employ this alternative to a long stock position even though in doing so they are foregoing any dividends that might be received if they owned the underlying stock rather than the options.
When using option spreads to establish either a directionally biased trade when the investor expects a move in a particular direction, or a non-directional credit spread to generate income no matter which way the market goes, there is an additional “insurance” move the investor can employ.
When holding a bull put spread, the investor can use one or more “extra” long put positions at the Strike Price of the long member of the spread. If there should be a sudden big drop in the market, those extra long put options will offset some or all of the loss the rest of the spread is experiencing during the crash – flash or otherwise.
Monthly stock option credit spreads also can (and should) completely avoid one of the sources of flash crashes: a surprising earnings report miss. The wise credit spread investor uses this “The Monthly Income Machine” trade entry criterion no matter what technique and trade entry criteria he is using to establish his credit spreads. Specifically, he does not establish a monthly option credit spread until AFTER the scheduled earnings report comes out.
Dangerous Techniques for Avoiding Flash Crash Effects
There are two approaches to defending against flash crashes that require a warning statement, namely: don’t use them.
Both involve “stop loss” orders.
1. Stop Limit Orders
The stop limit order tells the brokerage firm to only execute the stop order if it can be filled at the specified trigger price or better, i.e. if “slippage” in fill price would result, don’t execute the order.
Conversely, regular stop orders are filled “at the market” if the trigger price is reached or exceeded and because of the gap down in price during a flash crash, the investor not only would have abandoned his position unnecessarily, but his regular stop order would likely be filled at far below his actual stop trigger price. Investors, understandably, hate this!
In my broker days, I frequently had to try to talk clients out of using the stop–limit type of order to prevent the potential bad fills of a regular stop loss order. The attraction to it was that if the market suddenly gapped down and then recovered quickly, the client would be better off by having an unfilled stop limit order thus remaining in the market and benefiting from the flash crash rebound phase.
However, this apparent benefit of stop limit orders – not being stopped out unnecessarily if it does prove to be a flash crash, or being assured of no slippage on the stop limit order if executed – is more than offset by a very significant potential problem.
If it’s not a flash crash, but a major collapse in the price that is actually “warranted,” the investor is left holding a badly deteriorated position that may well continue to deteriorate – even potentially all the way to zero. (Did I just hear someone mutter, “That never really happens?”)
During my broker days, a close broker-friend of mine had a client who not only stubbornly refused to get out of a large position that was clearly now trending (not flash crashing) down, but he was “dollar averaging” and bought more and more of the stock as the price fell. The stock was the now defunct company – Enron.
2. I’ll Watch It”
If there is a tactic more dangerous than the stop limit order for protecting against a flash crash, that would be the infamous “I’ll watch it.”
Here the investor is saying in essence: “if I place an actual stop order on XYZ in the market, ‘they’ will come and get it and stop me out… after which XYZ will go straight up.”
Instead, he decides to “watch” it (no bathroom breaks, no “birds and bees” talks with the kids, no getting a haircut, etc.) and will somehow “know” when it’s time to exit from a position. He feels this is more rational than using an objective value as his exit signal – one that will be executed no matter what he is doing or where he is. In my experience, “watching it” can – and often is – very injurious to one’s financial health!
The Bottom Line
Although there can be a myriad of reasons for a flash crash, the specific actual cause is rarely clear and is really irrelevant at the time. The fact that is relevant is that there is no way to know at the outset with any certainty if a sudden collapse in price is a flash crash or a significant trend development.
As discussed in this article, however, there are action steps the industry and the individual investor can take to minimize the potential adverse effects of a flash crash if/when one occurs.
Circuit breaker regulations already in place.
Favor more liquid, actively traded stocks and options.
Buying a protective put option to protect bullish stock position.
Using outright option purchase, or directional spread, instead of underlying stock.
Include extra “long” position(s) in credit spreads.
Do not establish credit spreads during earnings report month.
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Options Income Specialist –
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Email contact: Lee@SaferTrader.com
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