After the ‘flash crash’ on the British pound last week, traders have either profited from the drop or been hit with a massive loss.
In this quick article we’ll look at possible reasons as to why it happened and how we can react to it in terms of our Trading.
Several theories have emerged about why the British pound tumbled from about $1.26 against the US dollar to about $1.18 in just two minutes on Friday morning, but we may never know the precise reason despite the Bank of England looking into the cause. Foreign exchange markets are complex. There are many trading systems operating in the market across time zones and there’s no single collector or provider information.
The crash happened just after midnight London time, when liquidity in Forex markets is typically low. Forex trading in Asia is spread across many key centres like Tokyo, Hong Kong, Singapore and Sydney. But low liquidity itself isn’t a cause for a so-called “flash crash”.
It could be down to a so-called “fat-finger” trade where a person types in a wrong number in an order. In a market increasingly dominated by algorithmic trading done by computers it could also have been caused by a glitch in a programme (‘algo’ for short). These sorts of glitches have happened before, notably in 2010 in the US stock market. If it was a fat finger by a person at a bank, we should have found out fairly quickly as counter parties acknowledge the error and wipe the trades out. If it’s an algo glitch, then we may never find out.
There are other possible explanations that are often trotted out when market moves can’t be explained, including a build up of stop loss orders at a certain point and when those are triggered there’s a large subsequent move.
There’s not a lot traders can do about flash crashes. They can’t be predicted, and thankfully they’re rare. But sterling markets have been highly volatile ever since the UK voted to exit the EU, and traders need to consider mechanisms like guaranteed stops.
It also pays to use common sense – the pound is now highly susceptible to the kind of surprise headlines (‘tape bombs’ to use the lingo) that can cause rapid movements in prices. As well as using guaranteed stops, it makes sense from both a financial and a psychological approach, to use smaller position sizes. FX markets are volatile at the best of times, but now news flow is combining with low liquidity (compared to previous years) to make this asset an even more volatile place.