Soon after the Great Recession, the U.S. stock markets plunged – and rebounded within 36 minutes. The Dow Jones Industrial Average dropped more than 9%, losing more than 1,000 points before suddenly recovering.
PREDICTING THE NEXT STOCK MARKET
This May 6, 2010 event was the first recorded “flash crash.” While it didn’t have long-term effects, it raised concerns among investors about the stability of stock market. Computers have made trading faster and more efficient, but they also can create instability in the markets. Today, quantitative analysts use complex algorithms to make many trades in many markets within a fraction of a second. These new algorithms now account for more than half of all trades. But this may lead to even more flash crashes. As engineers, we were interested in that May 2010 crash. No single reason can explain why flash crashes happen. But are there ways to predict and mitigate these anomalies? We took on the challenge of developing a theory that may help predict flash crashes. THE FLOWOF MARKETS We started with fluid dynamics, the study of the flow of fluids such as water. These principles can be applied to other problems; one of us previously used fluid physics to examine the movement of traffic. In fluid dynamics, researchers look at how measured quantities, like velocity and
pressure, affect the dynamics of the flow. For example, weather forecasters use the changes in wind speed and pressure to predict the movement of severe storms. We asked ourselves: Could this science give insight into the dynamics of the stock market? We felt that the existing theories predicting flash crashes are inadequate, because they focus on only a small part of the whole picture, like the performance of some subset of stocks. Dow Jones or the S&P 500 indexes
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