Lessons from Past Flash Crashes – Introduction
October 19, 1987 started like an ordinary day in Wall Street. But, by the events that happened that day will reverberate for years to come. Out of the blues, the market which were rising tanked. The U.S. markets fell by 22.68%, the Canadian market fell by 22.5% and the Hong Kong market fell by 45%. The reason for the crash was not immediately known but the markets rallied later.
The same happened on September 11th, 2001 when the United States was attacked. The markets fell by double digits before recovering in the following days. The same happened on May 6th, 2010 when out of the blues, the markets fell when a guy from London manipulated the market. That day, the Dow fell by more than 500 points before recovering minutes later.
A similar – albeit – smaller event happened on Friday when an ABC News reporter reported crucial information about the Russian investigation. The reporter claimed that during the election, Trump asked Mike Flynn to contact Russians. The Dow fell by 350 points and the NASDAQ by 105 points. The markets recovered slightly when ABC clarified the news later.
While we can’t predict whether such flash crashes will happen in future, chances are that they will. We can’t predict when, but we are mostly certain that they will. This is because as the market becomes increasingly automated, such happenings will continue. Therefore, as a trader, you need to know several things.
- First, when a flash crash happens, all – including the pro traders – are caught off-guard. They are caught unawares because, no one can accurately predict that such a crash will happen. No algorithm or artificial intelligence tool can predict if or when such a crash will happen. They just happen. So, everyone is usually caught unawares, and most people lose a fortune when such a thing happens.
- Second, the thinking of a flash crash is the key foundation of having a stop loss. A stop loss helps protect an account when such a thing happens. For example, assume you bought the stock of a company at $15. Then, if there is a flash crash and the stock falls to $10, a stop loss at $13 will help protect your account from total loss. Therefore, you should always have a stop loss to protect your account from such a flash crash.
- Third, the idea of a flash crash applies very much when you think about risk management. This is a topic I have talked about several times before. The concept is simple. When you open a trade, you should think about the maximum loss you can make and the maximum profit. For example, assume you bought a bitcoin when it was trading at $300. At that time, the biggest loss you would have made would have been $300 if bitcoin dropped to 0. However, the bitcoin is currently trading at $11,500 which means that your profit would have been infinite. The same thing happens in trading. You should always do your risk analysis before you initiate your trades.
- Fourth, when a big movement happens, you should not always rush to exit. This is because a reversal can happen. This has proven to be the case when a flash crash happens. Immediately, the market falls but later on recovers. Therefore, if you see a major market crash, and you have your trades on, if the stop loss is not hit, you can continue holding on the position. This is because a reversal can always happen.
Finally, flash crashes teach us that no one knows everything. In other words, there are no market pros. If they existed, they would warn us about them.