ETFs And The Next ‘Flash Crash’

MarketWatch featured an article on the flash crash of May 6, 2010. Here are some highlights:

The ‘flash crash’ turned the stock market on its ear during one violent trading day a year ago, but many investors are still vulnerable to the market’s next bungee jump. Their mistake: stop-loss orders on exchange-traded funds — a move that puts shareholders directly in harm’s way.

Stop-loss orders come in a number of varieties, and can be a smart strategy for protecting profits. The fundamental idea behind them — a set price to exit a security — makes sense, even for a long-term investor who tries not to be swayed by momentary market movements.

That said, the flash crash on May 6, 2010 exposed how the best intentions can create real problems.

Now go back to the flash crash, when the Dow Jones Industrial Average DJIA +0.36%  lost 1,000 points, then recaptured 650 of that before the close. In one harrowing 15-minute stretch the market lost about 500 points then got it back. Critics say the incident wiped out more than $850 billion in market value.

An ETF investor with the foresight to put a stop-loss order in place may have thought they were protected against such steep price drops. In fact, using a stop order instead of a “stop-limit” order hit them with the worst of the market’s pain.

During the flash crash the market dropped so fast that instead of getting the pre-determined price, investors got something much lower. Crucially, their stop order simply instructed a sale at the next available market price below the threshold.

Instead, had they used a stop-limit order — selling at $80 per share, but not lower than $75 — their order would not have been filled. While the ETF hit the sell price, no trade could be executed within the $5 range of the order because the market was in free-fall.

“Stop losses are a really bad idea for ETF investors, and the flash crash showed that,” said Paul Justice, director of ETF analysis at investment researcher Morningstar Inc. “It makes no sense to put yourself in a position to lose a lot of money to a spike in the market, and that’s what can happen here.”

I agree with what’s being said above. Let me again talk about sell stops and how to use them. To avoid participating in a disaster like a flash crash, you want to work with what I call a “soft sell stop.” In other words, you never put your sell stop in ahead of time.

In my advisor practice, I use closing prices only to determine if a sell stop point has been triggered. If it has, only then will I enter the order to sell the affected position the next trading day. That means I may end up getting filled somewhat better or worse than my intended 7%. Since that is not a hard number anyway, but merely a guide, I am comfortable with it.

Stay away from placing any orders during a day of market turmoil. You never know if and when you get filled, and it’s very difficult to get timely and accurate data from your custodian.

Use day ending prices as your sell stop guide and consider intra-day events as nothing but market noise that should not affect your long-term strategy.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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