How One Man Could Tank the Stock Market

Imagine for a second that you want to make money on Craigslist—and you have no scruples.

How might you go about it?

One creative idea: You make a bunch of fake Craigslist posts pretending to sell something lots of people want—say, a recent model of the iPhone. Other people selling that phone on the site notice your posts, get nervous about the glut of competitors, and start cutting prices aggressively so they don't get stuck holding a worthless model. When prices plunge low enough, you swoop in and buy a bunch of (cheap) phones—and then delete all your fake posts. Suddenly, it seems like the supply of that iPhone is low, and prices go back to normal. And that's when you sell the phones...at a big profit.

Sounds pretty nefarious, right? Well, that's essentially what federal prosecutors claim British trader Navinder Sarao was doing during the 2010 flash crash, when U.S. stocks lost a trillion dollars in value before rebounding moments later. Except instead of iPhones on Craigslist, he was selling E-mini S&P 500 contracts in the futures market (buyers of these futures contracts are betting the market will rise; sellers that it will fall).

According to an FBI criminal complaint, Sarao made nearly $1 million the day of the crash by posting bluff sales orders priced so they would never actually be executed and then buying up contracts once prices dropped as a result of his orders: an activity called "spoofing." In the hours before the crash, the Feds claim he was responsible for more than 20% of the downward price pressure on the market.

In fact, the government says Sarao has been using spoofing techniques for years, turning to computer automation to post huge orders quickly and en masse—and cancel them anytime they got close to actually going through. His profits since 2010? About $40 million, according to the complaint.

You might wonder, "well how did this guy get away with making so much money with such big fake orders without anyone noticing?" The answer, according to emails obtained by the government, is that Chicago stock exchange authorities did notice. And when they contacted Sarao to tell him to stop, he reportedly told them "kiss my ass." Between that and the fact that he set up a corporation (on a tax-free Caribbean island) literally called "Nav Sarao Milking Markets," it's pretty wild it took authorities five years to arrest him.

As Michael Maiello at The Daily Beast says, "They saw Sarao entering phony trades and responded by sending him letters... this is no surprise. Exchanges don’t make money by kicking people out of the game."

Now, as distasteful as his alleged actions sound, nobody is really claiming Sarao caused the flash crash singlehandedly. An early report from the SEC acknowledged many other factors were at play, including "unsettling political and economic news from overseas concerning the European debt crisis," which made the markets much more skittish than usual.

"99.99 percent of the time, a spoofing strategy is not going to cause a flash crash," says Larry Tabb, founder of the research firm TABB Group.

Indeed, Sarao allegedly kept spoofing enormous orders for years after the crash without another one occurring.

But it's clear that one individual can at least have an outsized influence on the market, says Spencer Mindlin, a research analyst at Aite. When investors are already nervous and there is the illusion of big sellers trying to unload a bunch of securities all at once, it can spread a contagious fear that the market is headed downward, which then becomes a self-fulfilling prophesy.

One theory is that Sarao's spoofs triggered futures contracts sales by Kansas-based investment company Waddell and Reed—to the tune of $4.1 billion—and it may have been that huge movement that led to the cascade of sell-offs.

"Nobody wants to catch falling knives," says Mindlin.

So what does this all mean for you and other ordinary investors minding their retirement portfolios? On the one hand, this news is pretty discouraging. As Matt Levine at Bloomberg says, "It's not ... confidence-inspiring to read that a guy with a spreadsheet can trick everyone into thinking that the market is crashing, and thereby cause the market to crash."

But there's good news.

For one, it's theoretically less likely that a similar flash crash could occur today, thanks to new circuit breakers used by exchanges that pause trading temporarily when the values of stocks and other securities drop too rapidly over a short period of time.

The time when trading has halted "allows supply and demand to recalibrate," says Tabb.

Additionally, a flash crash generally won't affect long-term investors who don't day-trade, since it lasts just a few moments and prices bounce back almost immediately. The only people hurt are those on the other side of lousy trades, which today are typically high-frequency traders using robots. Though there are exceptions, of course, like one retail investor who was ill-fated enough to sell right at the minute of the flash crash in a move that cost him nearly $20,000.

More importantly, just because you don't lose money in a flash crash, it doesn't mean you aren't affected by it. Arguably, the worst thing about a flash crash is how it erodes confidence in the fairness of the market.

Investment firm Glenmede estimates that the nearly $2 billion of outflows from equity mutual funds in 2010 was at least in part because of investor fear following the flash crash.

"That's money pulled out of the market that then couldn't be used to work for the economy and help companies grow," says Mindlin.

In other words, it's money that could have—but didn't—end up in your retirement portfolio in the form of higher returns.