Flash Crash: Is Technical Analysis the Smoking Gun? 

Sometime in the 1990s, Bill Gates achieved his goal of putting a computer on every desk. Since then, i.) academic studies have noted that the edge once attributed to indicator-based technical trading rules has practically disappeared, and ii.) it’s become obvious that most professional managers do the same thing as everyone else.

Much has been written about the so-called Flash Crash. From the start, my thesis has been that there is no conspiracy. If anything, it was the proverbial packed nightclub that caught fire. Since Friday’s revelation of the timeline of trades executed by the investment firm Waddell & Reed, we may finally have the smoking gun:

Gary Gensler, chairman of the Commodity Futures Trading Commission, said in congressional testimony Tuesday that regulators were focusing on one particular trader in the market for E-mini futures as part of the commission’s investigation into the flash crash.

Gensler said the trader in question entered the market at around 2:32 p.m. ET on May 6 and finished trading by around 2:51 p.m. ET. He said this trader and others had executed hedging strategies of similar size previously.

The Tipping Points

What is the smoking gun, you ask? I say it was the execution of stop loss orders amassed at levels based on popular technical trading rules:

  1. Investment guru William J. O’Neil wrote “in his second book 24 Essential Lessons for Investment Success, “find it gut-wrenching and hard to admit” they were wrong when a stock loses money, but they must overcome that emotion and sell anyway – an essential move if a stock has lost between 7 and 8 per cent from your purchase price.”
  2. Popular financial blogger and portfolio manager Mebane Faber’s timing model “mechanically buys (sells) an index when it crosses above (below) its 10-month simple moving average”, according to CXO Advisory. SSRN shows that Faber’s paper has attracted 138,520 abstract views, 51,516 downloads and is number 4 in download rank of all time. His book, The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets, features the 10-month moving average model. It’s Amazon.com Sales Rank is #19,207 in Books.
  3. Stan Weinstein’s classic, Secrets For Profiting in Bull and Bear Markets has advised using the 30-week moving average for timing for decades.
  4. Finally, there is the ubiquitous 200-day moving average that is on plotted on every chart, a line Louise Yamada once defended the use of based on “observations noted over time.”

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