Flash Crash

by Liam Vaughan

  The closest thing to a bible for traders is Reminiscences of a Stock Operator by Edwin Lefèvre. Published in 1923, it recounts the early life and wisdom of Jesse Livermore, a trading guru who went from watching prices on a bucket shop ticker tape at fourteen to making and losing a fortune many times over. At Futex, wet-behind-the-ears graduates and grizzled veterans alike mined well-thumbed copies for insights. It was said that Livermore, who was given the nickname the ‘Boy Plunger’ for his habit of profiting from financial crashes, could ‘read the tape’ – that is, he could look at price movements in a security or future and accurately predict where it was heading based on his careful study of past behaviour. The reason for the move was almost incidental, he maintained. What mattered was that it would move and which way. ‘There is nothing new in Wall Street,’ wrote Lefèvre, channelling Livermore in a famous passage. ‘There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again. I’ve never forgotten that. I suppose I really manage to remember when and how it happened. The fact that I remember that way is my way of capitalising experience.’

  Sarao may not have reached the same heights as Livermore, and his lifestyle was certainly more abstemious than the freewheeling, three-times-married American playboy, but, years later, his peers at Futex would point out some striking parallels. Both started out with nothing on the fringes of finance and had photographic memories; both could divorce emotion from their decisions and were willing to risk ruin for a shot at glory; both prided themselves on the conviction of their calls and hated discussing trading with anyone else lest their instincts be contaminated. They would both also end up inextricably linked to market crashes. Livermore, who earned $100 million shorting stocks in 1929 – the equivalent of more than $1 billion today – ended up squandering it all and shooting himself in the head in the cloakroom of the Sherry Netherland Hotel in Manhattan in 1940. For those paying attention, Livermore’s life is a cautionary tale about the dangers of blind obsession and the perils of tying your destiny too tightly to the whims of the market. The traders at Futex only ever talked about his legendary skills.

  CHAPTER 3

  THAT’S A FUGAZI

  A few weeks before Nav joined Futex, a post titled ‘Elliot and Gann analysis exposed’ appeared on a popular day-trading forum. Its author was a newcomer to the boards who called himself ‘That’s a Fugazi’ and used a picture of the Joker as his avatar.[fn1] On the brief bio attached to his profile, he described his trading style as ‘WINNING – period. Losses do occur, but only as often as the soccer World Cup.’ Under ‘list of markets traded’, he wrote: ‘I’d trade fruit and veg as long as it made wonga.’ The signature that ran along the bottom of his posts read: ‘OH SHEEP COME JOIN THY SHEPHERD IN THE LAND OF THE RICH AND BEAUTIFUL!’

  When Nav created his online alter ego, he was a newcomer to trading, twenty-four years old and still buying and selling individual stocks rather than the index futures that would make him rich. His idiosyncratic way of seeing the world and preternatural confidence, though, were evident from the start. Indeed, his opening gambit on the site was a repudiation of two of the godfathers of trading theory. Ralph Nelson Elliott was a Kansas-born accountant who, in 1938, published a book called The Wave Principle that posited that markets move in discernible and therefore predictable wave formations based on the ebb and flow of crowd sentiment from optimism to pessimism. According to Elliott, while markets might appear to be random, they are in fact governed by recurring patterns grounded, like much in nature, on the Fibonacci sequence. Sarao was unconvinced: ‘I am well versed in Elliott waves – indeed I have the E-wave bible and have made some astounding predictions based on it. Yet I soon realised, after throwing away my rose-tinted glasses, that 70% of the time a chart can fit numerable e-wave patterns of [sic] no pattern at all. Which means one is up the proverbial creek if one is limited to that technique.’

  Writing around the same time as Elliott was William Gann, a Bible-toting son of a Texas cotton farmer who sought to apply principles gleaned from geometry, astronomy and astrology to forecast cycles in commodities markets. Nav gave Gann even shorter shrift: ‘Well let me tell you all that literally a 12-year-old kid could use this method, it’s a simple method of algebra, an intellectual mind like mine does not even require a calculator for this one … I challenge anyone here to name a way Gann has helped them make money.’

  Nav wasn’t the first person to question the principles of technical analysis, a school of trading that uses charts and statistics rather than economic fundamentals to try to predict the direction of prices. Elliott and Gann had both been dead for half a century, and their respective methods had been so widely pulled apart they had reached the status of sacred cows in some quarters. But his blunt assuredness was striking for someone who had barely formally studied finance and whose trading experience was confined to buying and selling a few stocks. It was akin to an economics freshman discounting the work of John Maynard Keynes or an unpublished writer ripping into Charles Dickens. One of Nav’s objections, beyond his contention that Elliott’s and Gann’s methods didn’t work, was the idea that the universe and everyone in it were governed by some overarching natural law. ‘Which means that in essence EVERYTHING HAS BEEN WRITTEN BEFOREHAND,’ he wrote. ‘You need to believe EVERYTHING [sic] LITTLE THING IS DESTINED. That we are mere robots without any free will or choice.’ Nav prided himself on being a freethinker who formulated his own views about the world based on the abiding principle ‘Do Your Own Research’, or DYOR. ‘I wish I could tell you, (the sheep) the way to unlock yourselves from following the herd,’ he wrote in a follow-up post. ‘[M]ost of you are doing it without even knowing it, we are all programmed form [sic] birth to follow society in fashion, values etc etc and must atune our minds to think independently.’

  That’s a Fugazi’s critique proved predictably contentious. Some of the forum’s members jumped to Elliott and Gann’s defence. Others mocked Sarao’s unpolished delivery. ‘Please accept my sympathy by the way, as it sounds like your bedsit floor must have collapsed,’ wrote one. ‘I’ll have a pint of whatever Mr Fugazi is drinking,’ wrote another. Nav failed to see the funny side and accused them of lacking the intellect to understand what he was saying. ‘SHEEP ARE HOSTILE WHEN ENCOUNTERING BRILLIANCE,’ he wrote. The exchange set the tone for Nav’s activity on the forum over the next few months. Under the guise of talking about trading he would abuse his fellow posters and make outlandish claims about his own talents. He posted a poll titled ‘Can Fugazi tell the future??’ with options that included ‘Maybe, but it’s kinda scary to face up to what he predicts’ and ‘No more need for crystal balls, he knows it all’. He also claimed to run a seminar on ‘trading and LIFE’, but when pressed about how to sign up, he declined to provide any details.

  At first, the other forum members found That’s a Fugazi’s posts, with titles like ‘Proof of pure unadulterated genius’, amusing. They were full of references to ‘mugs’, ‘moola’ and ‘tings’, which earned him the nickname ‘The Sage of Peckham’, a working-class neighbourhood in London. One poster asked if he was Ali G. But by the summer the entries had started to take on a darker hue. With the Iraq War raging and 9/11 fresh in the memory, Nav claimed he could foresee terrorist attacks thanks to his unparalleled ability to read financial markets, ‘the most powerful predictive tool in the world’. When fellow posters complained he was being insensitive, he wrote: ‘Unlike the majority, I prefer to face the truth no matter how horrible it is, and until civil war breaks out in the UK and elsewhere as it will in the next 15yrs, the future will be a scary and horrible one.’

  By now Nav had been at Futex for a few months, and a clear chasm existed between his larger-than-life online persona and the enigmatic young man who made his way to Weybridge each day to learn to trade futures in the real world. At work, Sarao was hardworking and quiet; not exactly lacking in confidence but somewhat awkward and preoccupied. Then, each eveni
ng, when his fellow recruits headed off to the pub, he returned to Hounslow and unchained the increasingly megalomaniacal Fugazi once more. ‘Hello all, I know you missed me but you won’t admit it,’ he wrote one day that summer, before assessing the statistical likelihood of a biological or nuclear terrorist attack (80 per cent) and the assassination of George W. Bush (20 per cent).

  ‘I am going to be accused by many a sheep of being part of Al-Qaeda,’ he went on. ‘This is the typical retort when one is stuck of ideas. First let me expalin [sic] to you that I am not Muslim, so that kinda rules me out I guess. It’s funny, the hypocrisy that lives in this world. I mean I’ll get dirty looks in the street for being brown skinned, yet there have been more white caucasian people convicted of Al-Qaeda attacks than of my community.’

  Eventually, That’s a Fugazi overstepped the mark. The forum’s administrators warned him about trolling and his fellow posters turned against him, blocking him from their feeds. ‘Anyone who seeks to gain by boasting of “predicting” terrorist attacks is beneath contempt,’ wrote one. Nav denied he was seeking to gain anything and suggested his critics had been ‘brainwashed by mass media’. Later that day he wrote: ‘apologies for the harsh tone. BUT THE SOLE REASON THIS WORLD IS IN THE STATE IT IS, IS BECAUSE NONE OF YOU CAN BE BOTHERED TO FIND OUT ABOUT THE WORLD YOU LIVE IN.’ For a couple of months, Fugazi disappeared from the boards before returning with a new thread about how he’d switched from trading individual stocks to index futures like the e-mini. ‘As you can guess I’m doing rather well,’ he wrote. But where the early posts had garnered dozens of responses, this time nobody bothered to reply. Amid the silence he pleaded: ‘Come back to your master oh herd, thou art nothing without Him.’

  CHAPTER 4

  THE TRADE I

  After years of patiently building up his account, Nav pulled off a trade at the start of 2008 that would catapult him into the big time and go down in history at Futex. The global financial crisis, which had started to make its presence felt the previous spring, was gathering pace. Markets lurched around on news of the precarious state of the economy and the measures governments and central banks were taking to shore up the system. Where the S&P 500 might previously have moved forty or fifty ticks in a day, it was now not uncommon for the index to jump around in a range of 5 per cent, more than five times as much. The turmoil may have been disastrous for the wider economy, but it was a boon for traders like Nav who thrived on the action. Sentiment had swung firmly from exuberance to panic, and there was easy money to be made. Every time a bank reported big losses or a hedge fund announced it was folding, the market reliably tanked. Quick-fingered scalpers had only to wait for news to come out of the squawk box, ride the downturn and get out a few moments later before the rest of the world caught up. Order books were full of forced sellers who had no choice but to offload assets to raise cash or hedge their mutating portfolios. There was always a heightened risk of disaster in such volatile markets, but life was generally sweet for Paolo’s squadron of day traders.

  Late one afternoon in early January, Nav was at his desk at the Cornerstone when he noticed something odd in the DAX, an index that tracks Germany’s thirty biggest companies. Despite the swirling negativity, there was a glut of buy orders waiting in the order book; and whenever the bids were hit, Nav observed, they quickly replenished. The result was that, over the course of the evening, while most US and European markets remained depressed, the German index actually crept higher. Somebody out there appeared to have an insatiable appetite for DAX futures in the face of strong signals that prices should be going down. Nav stood up and went to speak to Brad Young.

  ‘It’s the Chinese, I fucking know it,’ Young barked when Nav asked him what he made of the mysterious buying. Residing as they did on the fringes of the financial firmament, traders at Futex were inclined to indulge in conspiracy theories about sinister forces controlling the markets. If it wasn’t the Chinese, it was the Plunge Protection Team or Goldman Sachs or the Bilderberg Group. Young’s theory this particular evening was that the People’s Republic of China had become so rattled by the turbulence in the US financial system it had decided to shift some of its vast resources into Europe. It wasn’t completely outlandish. China regularly intervened in the foreign exchange markets to stabilise its own currency. Plus, whoever was buying up the DAX had significant firepower. For long periods there were hundreds of millions of dollars’ worth of bids sitting in the order book.

  Nav rarely discussed his trading strategies with other people. Partly that was due to fear that he would be pushed off his game, but he had also developed a finely honed bullshit detector. He’d long since decided that the trainers who came and went at Futex were full of crap. If they really knew what they were talking about, why were they wasting their time on a bunch of noobs? Even Paolo, legend of Liffe and the firm’s founder, received a roll of the eyes when he tried to offer Nav any words of wisdom. But to Nav, Young was different. He didn’t just talk a good game. He backed it up, risking tens of thousands of dollars when he felt good about a trade. And unlike Nav, he was a DAX specialist.

  Young grew up catching waves in a surf spot one hundred miles north of Sydney. After spinning up a bankroll buying and selling equities in between classes, he had moved to London to do some travelling and try his hand at trading futures. Outwardly laid-back, he had a fiercely competitive edge and a burning obsession with the markets that rivalled Nav’s. Back at Weybridge, their relationship had got off to a rocky start. Fed up with the state of the kitchen one day, Young had spent hours cleaning up, only for Nav to put a fish pie in the microwave without a lid. When the pie exploded, spraying the kitchen in gunk and leaving the cramped office stinking of fish, Young lost his temper and started shouting at Nav, who hurled obscenities back. After a tense few seconds, they both cracked up laughing. Since then a friendly rivalry had built up between Futex’s two stars. Still, while Nav had some cachet around the floor, Young was the one the rookie traders really wanted to be like, showing up to work dressed like he was going to the beach and going on exotic holidays every few months. If the team went to the pub early on a Friday, Young left his credit card behind the bar, asking only that they return the favour one day when they had some success of their own. Once, after a particularly profitable week, he ferried them all to a swanky bar in Kensington for a night out. Young was the living embodiment of why many of them got into day trading in the first place: a charismatic, happy-go-lucky master of his own destiny who made a shedload of money without answering to the man.

  Nav and Young agreed to keep watching the DAX and went home for the night. The following morning they saw that the index had opened 90 points lower, a substantial drop. Whoever was propping up the market had seemingly given up and gone to bed. Over the next few hours, DAX futures continued to tumble in line with markets around the world, but by late afternoon the wall of bids had reappeared and prices started to edge up again. It was surreal. During the regular trading day for stocks, from 9 a.m. to 5.30 p.m. Central European Time, German futures followed the global downward trend. Then, when the country’s stock market closed and volumes thinned out, DAX futures, which keep trading until 10 p.m. CET, began edging higher, like a salmon swimming against the stream. It wasn’t clear who was behind the phenomenon or why. As Jesse Livermore had noted back in 1923, it didn’t really matter. The important thing was that there was a trend that could potentially be exploited.

  That night, before heading home, Young and Nav devised an experiment. Both of them would sell a few DAX contracts and see what happened. If the market took a tumble, as it had the previous night, they would buy back the same number of contracts the next morning, closing out their position for a profit. If it didn’t, they would take the hit and move on with their lives. Generally speaking, it was frowned upon at Futex to leave a position open overnight because you couldn’t react quickly if the market moved against you. They needn’t have worried. The following morning the DAX opened 65 points lower, earning the
m more than $10,000 apiece. By day three, the traders around them had started to take notice. There still hadn’t been anything in the press that might explain the move, but the pattern was clear. Half the office followed their suit, hoping to piggyback on the nightly deviation between the German index and markets around the world. Once again, the market rallied before collapsing overnight, this time by 80 points.

  Nav and Brad had struck gold. For two weeks, they repeated their overnight trade, placing steadily larger positions before heading home to bed and praying their good fortune would hold. Time and again it did, and by the second week of January, Nav had gone from shorting a handful of contracts to betting two hundred lots a night, a $15-million position that yielded six-figure profits. Young made a decent return but couldn’t resist the urge to keep trading the DAX throughout the day, and he ended up giving back a lot of his winnings. Nav, in classic style, just ‘let it breathe’, betting the most he could, then leaving the market alone and going back to scalping the e-mini. The strength of his conviction never faltered, and by the middle of January his account balance had ballooned to more than a million pounds.

  ON SATURDAY, 19 January 2008, a thirty-one-year-old French trader named Jérôme Kerviel stood outside Société Générale’s imposing headquarters on the outskirts of Paris and texted his boss: ‘I don’t know if I’m going to come back or throw myself under a train.’ Waiting for him in a conference room inside were the head of the bank’s investment banking division and various other executives who had spent the past twenty-four hours frantically scouring Kerviel’s trading records after uncovering evidence of what they suspected to be a massive fraud. Over the next several hours, Kerviel confirmed their fears. Starting in 2005, he confessed, he’d been secretly placing unauthorised trades worth hundreds of billions of dollars. Unlike most of the firm’s elite traders, Kerviel, the son of a blacksmith and a hairdresser from Breton, had started his career in an administrative function, and it was there that he’d learned how to cover his tracks using a combination of fictitious transactions and forgery. He’d escaped detection because, for the most part, he’d been successful. In 2007 alone, he said, he’d made a profit of around $2 billion by correctly predicting the impact of the impending financial crisis. Bizarrely, he was never able to claim credit for his success, because nobody else knew about it. The story might have ended there, except Kerviel had recently embarked on his most ambitious foray yet.