You Need Three Butterflies to Cause a Hurricane

Abstract

The aim of this study is verifying the impact of high volatility, scarce liquidity and stop-loss orders on abnormal events like the May 6, 2010 Flash Crash. The paper assumes those three factors to be the main drivers, proposes a mathematical model based upon them and analyses audit trail data to verify whether those factors actually were at the origin of that event. It uses the concept of 'run', an uninterrupted sequence of trades all occurring in the same direction and compares volatility, liquidity and occurrence of stop-loss orders over the analysis period. The results found provide suggestive evidence that a combination of the three factors contributed to the crash. Each of them, taken individually, does not usually lead to extreme behaviours. Even two factors together may not disturb the orderly functioning of the markets but the combination of volatility, scarce liquidity and stop-loss orders may lead to a crisis.

Keywords

• flash crash
• abnormal market events
• volatility
• liquidity
• stop-loss orders.