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The 2015 Flash Crash Was One Year Ago Today. Why Did It Happen?

SPDR S&P 500 ETF ETF:SPY, Merck & Company, Inc. NYSE:MRK - The 2015 Flash Crash Was One Year Ago Today. Why Did It Happen?

On August 24, 2015 the S&P 500 plunged 5 percent within minutes of the open, in what became the largest “flash crash” since 2010. The sudden downward pressure led to a massive panic across the market.

One year later, the S&P 500 is over 300 points higher than the low of that day.

So what happened? Why did the entire market seemingly sell off, and then rebound just as quickly? PreMarket Prep co-host and veteran trader Dennis Dick explained why on Wednesday's show.

Lack of liquidity

According to Dick, the problem starts with the market's overreliance on high frequency traders to provide liquidity. Unlike the market makers of yesteryear, HFT's don't have to be the buyers of last resort.

“What you saw on August 24 was primarily due to lack of liquidity. There just wasn't simply enough buy orders on the book to absorb all of the selling pressure there. We are very reliant on high-frequency traders now for the majority of our liquidity," he said. "That’s fine 99 percent of the time. The other 1 percent of the time we have problems because they don’t have the affirmative obligations like specialists did back in the day. High-frequency traders these days can say ‘Whoah, I don’t know what’s going on, so I’m just shutting my systems down.’

"When they all shut their systems down, you get this vacuum of liquidity where there’s just no buy orders on the book.”

Market fragmentation doesn't help

This is the other key factor according to Dick: there are many different exchanges and the order routing between them can be inneficient.

“Back when I started in 1999, 90 percent of your orders were routed to the NYSE. Now we have 13 different exchanges where any of those orders could be routed anywhere, and you have 50 or 60 darkpools--and then you have off-exchange market markers too.”

The huge number of order routing options these days means that some orders could completely bypass liquidity. How? This is where the SEC comes in.

SEC Rule 611

SEC Rule 611 essentially protects the top of the order book. Here's Dick:

"What that means is if you send an order, and you're sending it to a different exchange, the exchange that's getting that order has to actually route out that order to whatever the best bid is at the top of the book. So if you have a huge order coming in, let's say to sell 50,000 shares, if there's a couple thousand shares bidding at the top of the book and [NYSE Arca] gets that order, and EDGX is at the top of the book, they have to route out the top of that order, the 2,000 shares, to EDGX. After that, they can bring the remainder of the order back to the original exchange."

In other words, the other limit orders may not execute. As a result, large portions of huge sell orders get executed on a single exchange at prices well below those listed on other exchanges.

"That's the issue with market fragmentation," he said. "If you're not routing orders efficiently...then you get into this issue where you see prices getting traded through and you see flash crashes on a specific exchange."

Related Link: How To Trade 50% Retracements

What happened at the market open?

All of this came to a head in the first few minutes of the market's open that day. The reason why the opening bell was so volatile is because for the first few minutes of trading, spreads are wider. So once a lot of aggressive sellers come in, there isn't as many limit orders on the book to absorb the excess supply. This is what causes a stock like Merck & Co., Inc., MRK a Dow compontent that's usually thick with liquidity, to fall from $56 to under $46 on no news.

"A stock that's usually very thick, falling 10 points in one trading session is absolutely incredible," said Dick.

And this is where the panic sets in, which of course makes everything worse.

"You feel sorry for the people who had stop orders out there. You feel sorry for the people who panicked that day and sold the open the open that day because they sold at a really bad price. And then looking at it the next day, they probably wanted to throw up."

On August 24, 2015, all of these factors, combined with growing fears about the imminent downfall of the Chinese economy, produced one of the scariest and most memorable trading days in recent history. It’s certainly not a day that most investors would like to repeat anytime soon.

Listen to Dick's full explanation in the clip below. PreMarket Prep is a daily trading idea show that airs live from 8-9 a.m. ET here. You can also listen to the podcast here.

© 2016 Benzinga does not provide investment advice. All rights reserved.