Could it happen again?

A flash crash is when a computer glitch causes a brief but frightening stock market crash. On May 6, 2010, p anicked selling drove the Dow down 1,000 points, the biggest drop on record. Fortunately, it recovered 70% of the territory.

What triggered the sell-off? The European Central Bank refused to further bail out Greece, whose failing economy caused riots in Athens where protesters yesterday set fire to a bank. killing three employees. Greece’s debt was downgraded to junk bond status by ratings agencies, which also junked the country’s banks, the debt’s owners. If the ECB lets Greece default, it could trigger defaults by other debt-laden countries like Portugal, Ireland and Spain. Investors who hold these countries’ bonds will wind up with huge losses. Since many of these investors are banks, LIBOR rose — reminiscent of the bank credit crisis .

There were rumors that the stock market drop was caused by bad trades, or by a credit freeze in European banks. although those rumors were not substantiated. The euro plunged to a one year low against the dollar. A flight to safety drove gold up to $1,200 an ounce, near its all-time record, and knocked the 10-year Treasury note yield down to 3.40 percent.

Most experts believe this flash crash was created by a computer glitch, although the exact cause was never found. However, the true cause was high frequency trading programs. These are run by computer algorithms that control 75-85% of stock market trades. When a world event, or a computer glitch, tells these programs that something unusual is happening, they automatically sell (or buy) according to their code. In any event, high frequency trading programs make any stock movement more intense, thus adding risk. (Source WSJ, A Glimpse Inside the Flash Crash , June 10, 2012)

The NASDAQ is famous for flash crashes. On August 22, 2013, the NASDAQ closed from 12:14 p.m. EDT to 3:25 p.m. EDT. One of the computer servers at the NYSE couldn’t communicate with a NASDAQ server that fed it stock price data. Despite several attempts, the problem couldn’t be resolved, and the stressed server at NASDAQ went down. (Source: WSJ, NASDAQ in Fresh Market Failure. August 22, 2013; Bloomberg, NASDAQ Three Hour Halt Highlights Vulnerability in Marker. August 26, 2013)

NASDAQ computer errors also caused $500 million in loses for traders when the Facebook initial stock offering (IPO ) was launched. On May 18, 2012, the IPO was delayed for 30 minutes. In other words, traders could not place, change or cancel orders. Once the glitch was corrected, a record 460 million shares were traded. For more NASDAQ failures, see Computer Bugs and Squirrels: A History of NADAQ’s Woes. August 22, 2013)

Is the Stock Market Rigged?

Michael Lewis, author of the recently released book Flash Boys , said that the presence of these sophisticated high frequency trading programs means that the individual investor actually cannot get ahead. The programs can take in massive amounts of data, and made split-second decisions and trades long before a human can. Companies who use them, like Goldman Sachs and JP Morgan, haven’t lost on a trade in years. For the average investor, says Lewis, the stock market is rigged.

On CNBC, Lewis defended his research to the CEO of BATS, the second largest exchange behind the NYSE. Like the NASDAQ, it’s an all-electronic exchange, only larger. Billionaire investor Mark Cuban said the risk of a bigger flash crash is far worse than any market rigged scalping.

How It Affects You

If Wall Street isn’t rigged, it may as well be. There is no way an individual stock picker can collect more information or trade ahead of these computer trading programs. That’s why so many asset classes are moving in tandem. These programs aren’t regulated, either.

However, the situation is not hopeless. Although it’s impossible to out-think these programs on a day-to-day basis, you can generally tell where the market is headed by following the business cycle. Keep a well-diversified portfolio. and adjust your asset allocation each quarter to make a decent return. Remember, it’s not how much you make, but how little you lose. Article updated May 20, 2014