The weirdly rational flash crash

By Felix Salmon
May 20, 2010
spreadsheet comparing the Dow's current level to what it looked like at the low point on the flash crash day of May 6.

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As the Dow started falling dramatically this morning, my colleague Frank Tantillo and I put together a Google spreadsheet comparing the Dow’s current level to what it looked like at the low point on the flash crash day of May 6.

It’s not all that easy to understand, especially now that the Dow seems to be rising again, but basically what I was trying to do was get a feeling for just how crazy the markets got on May 6. My intuition was that if the Dow today, near its May 6 lows, looked very much like the Dow actually looked on May 6, then the crash would be much more rational than if the Dow components today were trading at wildly different levels from where they were trading at the lows on May 6.

There’s a few weird bits and pieces in the spreadsheet. For one thing, because the Dow components’ low points didn’t all happen at the same time, the Dow didn’t fall quite as much as the spreadsheet makes it look. (The actual low point is in cell B2; the fake calculated one is in cell B34.) And what’s more, because there’s still a significant gap between the Dow’s actual level (in column C) and its low point (in column B), I created a new column (column F) which simply takes the current price and shrinks it so that the overall Dow works out to the May 6 low point.

The interesting stuff starts happening when you look at the difference between rational, real-world depressed stock prices today, and the crazy, flash-crash depressed stock prices of May 6: it turns out that there isn’t much of a difference at all. In fact, with the exception of 3M and Procter & Gamble, it seems that the Dow fell in a pretty rational manner on May 6. Those two companies overshot a lot, but everything else looks like it’s pretty much in the same ballpark today as it was at the height of the craziness.

If the flash crash was caused by liquidity completely drying up and computers doing insane things which make no rational sense, then it seems to me that the relative prices of the Dow’s 30 components wouldn’t have stayed as tightly correlated as they did: I don’t think there was a lot of relative-value Dow component arbitrage going on during those 15 minutes.

And clearly the absolute level that the Dow reached on May 6 wasn’t all that irrational either, since we got pretty close to that level today, just a couple of weeks later.

So while the volatility we saw on May 6 was crazy, and the speed of the drop was unprecedented, it seems to me that the stock market didn’t break, during those 15 minutes, quite as much as conventional wisdom says that it did. There were a few genuinely crazy individual prints, but overall, something seemed to be working.


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I’m totally going to deploy the phrase “noted efficient markets theorist Felix Salmon” at the next possible opportunity.

Posted by dWj | Report as abusive

Let’s wait and see what GS reports as their profit for that day. Front-running this had to be very fish-in-a-barrel. I’m going with the over.

Posted by Sensate | Report as abusive

whoa, you’re violating the first law of HFT scapegoating: no facts allowed. But since you’ve let the cat out of the bag, yes, if you examine the tick by tick data you discover a very sane, well functioning marketplace absorbing 240,000 odd ES contracts during 2:43, 2:44, and 2:45, and handling the hedging fallout of the sale of such massive amounts quite well, especially given the initial position of every market maker on the planet. Even in having its capacity completely overwhelmed, the liquidity provisioning system worked and did the rational thing given its finite capital: it got out of the way of the tsunami and lived to fight another day. Which happened about 5 minutes later when the market almost completely recovered the incremental loss from the -350 Dow starting point. Something functioned well indeed.

Posted by snick | Report as abusive

The levels just showed what the initial support level was where traders would start buying. Nothing strange at all. Looks like everyone is spooked enough to not buy at this support level though.

Posted by dicktracy150 | Report as abusive

Well, sure. That’s why everyone was so worried on May 6: there’s a good case that this is exactly where stocks should be.

Posted by MitchW | Report as abusive

Last time I saw such a drop was 1987. And it took all day, not 30 minutes roundtrip.

Don’t draw any conclusions whatsoever, other than one. The place was a falling knife everywhere but on the NYSE.

Posted by Beezer | Report as abusive

We’ve had two flash crashes since then

Posted by STORYBURNcom2 | Report as abusive

This is a test, only a test…..

Wait tell the real thing……..

Posted by chevenez | Report as abusive

Absolutely terrific techno-reporting! Remember, though, that the stock market is a MARKET. Every share sold has a buyer. When the market bottomed, there were buyers scooping up the detritus at bargain prices.

Posted by DavidMac1556 | Report as abusive

Very interesting. We at Nanex have completed our analysis of the Flash Crash of 05/06/2010. What we found may surprise you: Analysis_Intro.html

- Jeff

Posted by JDonovan | Report as abusive