What are crypto flash crashes: how to survive any flash crash

“The time to buy is when there’s blood in the streets, even if the blood is your own.”

Despite being said by British banker Nathan Rothschild centuries ago, the quote is one that still holds relevance to this day. During times of crypto flash crashes, emotions can often take over. This can impair a trader’s ability to identify opportunities when the crypto market is overcome by fear and uncertainty. Whether you’re intending to follow through with Baron Rothschild’s quote or are planning to mitigate the risk of your holdings, it’s important to have an action plan when crypto flash crashes occur. From understanding what are crypto flash crashes to mitigating your risk with possible actions, here’s everything you need to know with our crypto flash crash survival guide.

TL;DR

• Crypto flash crashes are swift dips in crypto prices that occur unexpectedly over a short timeframe.

• While such flash crashes seem to come out of nowhere, they're often the result of high-frequency trading errors, liquidation cascades, and black swan events.

• Regardless of crypto flash crash fears, crypto traders must maintain a cool head when trading during such market volatility and aim to protect their capital.

• Some crypto flash crash risk mitigation strategies include hedging with options, dollar-cost averaging, and overall diversification.

• As flash crash media chatter tends to cause panic and uncertainty, crypto traders must remember to ground themselves by staying informed of market happenings and stick to their trading plans.

What are crypto flash crashes?

Crypto flash crashes are sudden and dramatic drops in crypto prices that occur within a short timeframe. These events typically erase billions in market value, triggering a chain reaction that ripples across the crypto market that results in panic selling and emotion-based crypto trading. A steady recovery typically follows the flash crash as the market self-corrects and rebalances to find a new equilibrium price, as traders regain confidence in their long position.

Why do crypto flash crashes happen?

If you find yourself often asking why is crypto crashing, you might be surprised to know that crypto flash crashes can be triggered by a whole range of factors. Here are some reasons for crypto flash crashes that seemingly happen out of the blue.

High-frequency trading (HFT) errors

Also known as algorithmic trading errors, HFT errors can cause significant market volatility as thousands of orders flood orderbooks. These errors occur when automated trading algorithms malfunction, leading to massive sell orders being erroneously executed rapidly. This sudden influx of sell orders can then overwhelm the market, causing prices to plummet dramatically.

Curious as to what are some specific examples of HFT errors? They include the following.

• Fat finger errors: From additional zeros to unintended decimal points, accidental HFT parameter inputs may sometimes lead to unintended trade orders making their way to the crypto market.

• Algorithm glitches: Errors in the trading algorithm’s logic may cause unintended trades to be executed.

• Volatility-induced trading: When multiple traders are using similar HFT strategies, a sudden price drop can trigger a chain reaction of algorithmic trades, causing larger-than-expected price movements in the crypto space.

One such example of flash crashes crippling the market is the infamous 2010 U.S. stock market flash crash, where stock indices plunged as much as 9% within minutes, wiping out almost one trillion dollars in market value. After a thorough investigation, regulators discovered that algorithmic traders contributed to this crash with their attempts at market manipulation.

Market manipulation

Crypto flash crashes can sometimes be intentionally caused by blatant market manipulation in the crypto space. This involves specific illegal actions to deceive market participants and benefit from price fluctuations. Some examples of market manipulation techniques include spoofing, where traders place large orders to manipulate prices, and wash trading, where traders create artificial trading volume. When conducted on a massive scale, such actions can often contribute to flash crashes that work out in the bad actor's favor.

Liquidation cascades

Liquidation cascades are a particularly dangerous phenomenon in the cryptocurrency market that can exacerbate flash crashes. This occurs when traders employ leverage, borrowing funds to amplify potential returns. When the price of a cryptocurrency drops significantly, leveraged positions become at risk of liquidation, leading to a margin call demanding the trader add more funds to their account. If said trader is unable to meet this, the trader’s position is forcibly liquidated and the proceeds will be used to cover the loan incurred. As more traders face margin calls and liquidations, a cascade of sell orders floods the market, further depressing prices and triggering more liquidations. This vicious cycle rapidly accelerates the price decline, transforming relatively minor price drops into huge crypto flash crashes.

Black swan events

Unexpected and highly impactful events can also trigger crypto flash crashes. These black swan events can range from regulatory crackdowns and platform hacks to major market news or geopolitical events that send shockwaves through the crypto ecosystem. These unforeseen occurrences can lead to panic selling, exacerbating price declines and creating a cascading effect as crypto traders with long positions rush for the exits to protect their existing capital.

Thin liquidity

Unlike traditional financial markets, crypto markets often exhibit relatively thin liquidity. This means there's a limited number of buyers and sellers, making it easier for large sell orders to significantly impact prices. When a substantial sell order hits a thinly traded cryptocurrency, it can cause a substantial price drop due to the lack of sufficient buying pressure to absorb the sharp selling pressure. One recent example of this was the Bitcoin flash crash on BitMEX that caused BTC prices to go as low as $8,900. Upon further investigation, it was discovered that whale selling catalyzed the Bitcoin flash crash as the thin liquidity surrounding the XBT/USDT spot pair caused prices to be driven down.

Understanding these factors is essential for navigating the volatile crypto market. While flash crashes can be unsettling, knowledge of their potential causes can help traders develop strategies to mitigate risks and potentially capitalize on opportunities.

Crypto flash crash risk mitigation strategies

Now that we’re fully aware of why crypto prices tumble during flash crashes, it’s crucial to keep one’s emotions in check in the event of such massive declines and focus on creating a trading plan based on this volatility. From diversifying your crypto holdings across various assets to avoiding panic selling, here are several strategies to help mitigate the impact of sudden crypto flash crashes.

Diversification

Unless the crypto flash crash is a market-wide crash, spreading your holdings across different cryptocurrencies can help reduce the impact of a single coin or token's price crash. By diversifying, you're essentially spreading your risk across multiple assets. For instance, by considering a mix of Bitcoin, Ether, and other altcoins in your holdings, you can protect your portfolio from the volatility of a flash crash for coins within a specific sector like DePIN or DEXs.

Using stop-loss orders to limit your losses

Stop-loss orders are a valuable tool for mitigating losses during a crypto flash crash. By setting a predetermined price at which you’re willing to close your long positions, you can automate the selling process if the market takes a sudden downturn. If the cryptocurrency's price reaches your specified stop-loss price, the order is triggered, and your position is automatically closed, preventing you from incurring significant losses if the price plummets unexpectedly. In short, this removes the emotional stress of making quick decisions during a market panic, saves you time from constantly monitoring the market, and helps protect your capital by limiting potential losses.

Avoiding panic selling

In trading, emotional decisions often lead to poor outcomes. To achieve long-term success, it’s essential to stick to your trading plan and avoid impulsive selling during a crypto flash crash. As panic selling is a common reaction to sudden price drops in the crypto market, traders can avoid impulsive decisions that exacerbate losses and instead resist the urge to sell immediately. In doing so — and by acknowledging that it’s a crypto flash crash — there’s a chance the market will quickly recover, and traders with long positions can potentially recoup their losses over time.

Hedging against downside risk with crypto options

If you've already deployed sufficient funds to a position but are afraid of further volatility, you can still protect your holdings from crypto flash crashes by making use of crypto options to hedge against any sudden dips. This ultimately allows you to enjoy additional downside protection while remaining bullish with your original long position. From covered calls to protective puts, such options strategies are extremely effective in neutralizing the impact of any short-term volatility if you're keen to remain bullish for the long haul.

Sizing in with your positions and DCA when buying the dip

Echoing the mantra of buying when there's blood in the streets, crypto traders are often told to buy the dip when there's a huge crash. Unfortunately, this strategy is rarely explained in full detail as beginner crypto traders often have concerns, like the amount of capital to deploy and what to do if the crypto flash crash dips further than expected. One common approach to buying the dip is to use a dollar cost averaging (DCA) strategy. This involves deploying a fixed amount of funds regularly, regardless of the price. This helps to reduce the average cost of your long position over time, regardless of how much crypto prices crash in the short-term.

Avoiding the chatter and staying informed is key to flash crash survival

When it comes to surviving any crypto flash crash, it’s key to always keep a long-term approach in mind. During a crypto flash crash, it can be easy to panic and give in to the instinctive urge to dump your positions to cut your losses prematurely. This is because you’ll see media outlets begin to go into a panic-induced frenzy and cite all the reasons why the market is dumping, and how it can get worse.

While this may be suitable for those who are already leveraged and intend to double-down on their trading positions, it’s ill-advised to simply abandon a trade since nothing has fundamentally changed from the original trading idea. As such, the best thing to do is to stay on top of the latest crypto news so you’re aware of the reasons why the crypto flash crash is occurring.

Once the severity of the dip is known, crypto traders must decide how best to navigate the volatility that their holdings are exposed to, and decide where their long-term convictions lie. Whether you’re intending to buy the dip or simply HODL through the fear and uncertainty, it’s key to stay informed, maintain your composure, and stick to your overall trading plan so you don’t make trades based on your emotions.

Final words and next steps

From mitigating risk for existing holdings to understanding the importance of long-term conviction with a personal trading plan, we hope our guide to surviving crypto flash crashes has proven useful. Crypto flash crashes are a stark reminder of the market’s volatility and the potential for sudden, dramatic price declines. As such, understanding the causes of these events and implementing effective risk mitigation strategies is essential for navigating the crypto landscape. Since the crypto market is constantly evolving with its many twists and turns, staying adaptable and informed is key to surviving and thriving in the long-run.

Want to read more about the inherent volatility of the crypto market? If so, check out our guide to crypto market volatility. Also, if you intend to learn more about the macroeconomic forces impacting the crypto markets, read our take on how U.S. Federal Reserve meetings impact crypto prices.