The ETF Flash Crash

In the early minutes of the stock market open on Monday morning things got a little crazy. After a huge whoosh down in overnight futures trading, the NASDAQ fell almost 9% while the S&P 500 was down around 6% right after the opening bell. Watching it in real time was a sight to behold. Less than 15 minutes later, a huge chunk of those losses were recovered. Many individual stocks saw even larger moves.

There are rules in place that dictate that the markets have something of a 5 minute cooling off period when they rise or fall by more than 5% in short order. Regulators are trying to slow a huge rise or fall in a stock from getting out of hand. There are obvious side effects to these rules and the overnight gap risk is something they can’t really control. These circuit breakers were triggered in all kinds of stocks Monday morning as investors and computers hit the sell button right at the open in hopes of getting out before things got out of hand.

ETFs weren’t spared from these rules and it quickly created some problems in some of the largest and well-known funds. Here’s the Guggenheim S&P 500 Equal Weight 500 ETF (RSP):


And the SPDR S&P Dividend ETF (SDY):


These funds were quickly down 30-40% as circuit breakers were triggered in both the underlying stocks and the ETFs themselves. This has led many to say that ETFs are part of the problem and that they are dangerous products. I don’t see this as ETFs being broken. This has more to do with those who are trading these ETFs and the underlying securities.

ETFs are exchange traded funds. They trade daily on the market exchanges (to state the obvious). Mutual funds, on the other hand, trade just once a day at the closing NAV price. To receive the benefit of daily liquidity you will at times have to deal with intraday market craziness, which could be amplified these days by computer trading systems and irrational market participants.

The algorithms and systematic trading systems probably had a lot to do with this as their auomatic triggers were hit, but there were also a few unsuspecting individuals who got dinged in the process. The Wall Street Journal ran a piece about the ETF issues and highlighted an advisor who got stuck with some of the bad prices on Monday morning:

Lansing, Mich.-based financial adviser Theodore Feight had set up an automatic sale for iShares Core U.S. Value ETF if it were to fall a certain amount. The ETF tumbled 34% in early trading, and instead of Mr. Feight’s position selling at his target price of $108.69, down 14%, it sold at $87.32, off 31%. By noon, the ETF had bounced back, and it ended the day down 4.3% at $121.18.

“I’m really disappointed,” said Mr. Feight, who invested in ETFs for more than a decade. “They weren’t as liquid as they should have been.”

Whenever something goes wrong in the markets (read: losses), people tend to look for someone or something to blame. If you put in a market sell order and there’s no one else who’s willing to take the other side of that trade at the price you’d like, you’re stuck with whatever price the market is currently throwing out there. This has nothing to do with the mechanics of ETFs, price discovery or liquidity and everything to do with user error.

I would be much more concerned if these huge dislocations weren’t fixed very in short order, but they were. Investors quickly stepped in to remedy the situation as you can see from the charts above. If you’re trading ETFs you can probably expect something like this to happen again. If you’re a long-term investor in ETFs I don’t see why something like this should be a concern to you.

For some reason, many investors operate under the assumption that markets should be perfect at all times. They never have been and they never will be. These hiccups are not “flaws in the modern market system.” They are flaws in human nature and poorly designed trading systems. It doesn’t matter what rules and regulations are put in place. These panics will happen on occasion.

Carlson’s Common Sense Investing Rule Number 27 states that you should never put yourself in the position of being a forced seller in the markets. This goes double during a panic. When investors (and quant trading systems) panic, markets may not always work the way you would like them to.

Stock-Market Tumult Exposes Flaws in Modern Markets (WSJ)

Further Reading:
Liquidity Risk: Same as It Ever Was

Here’s what I’ve been reading this week:

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What's been said:

Discussions found on the web
  1. Gregory commented on Aug 28

    This overreaction creates a good opportunity to buy for a value/contrarian investor. And Burton Malkiel and others are right: markets are efficient. Just In the long run.

    • Ben commented on Aug 28

      I like to say that the markets are more or less efficient most of the time. But they’re never going to be perfectly efficient, especially over the short-term.

      • Brooklyn Bum commented on Aug 28

        Markets are as efficient as people. There are a lot of inefficient people btw….. This efficient market theory is what makes people so naive and reckless (without knowing it until its too late, and blame it on wall street)

  2. Pete Nikolai commented on Aug 28

    The “automatic sale” used by the trader who got burned was probably a trailing stop loss order which can be helpful in preventing a minor loss from becoming a major loss. After considering the sequence of events, that particular weakness of trailing stop loss orders becomes apparent.

    Solutions include using trailing stop limit orders (but those can remain unfilled if the price is declining rapidly so there is no buyer at the limit price) or conditional/contingent orders with a stop price at $x that triggers a limit order at $x minus $y (which can still remain unfilled if there is no buyer at that limit price). Perhaps the best solution is using a trailing stop limit order and having it either execute as planned or remain unfilled on the way down. If it is remains unfilled on the way down then it may execute on the way up since many rapid declines are quickly reversed later that day.

    However if the order does not execute and the investor is left holding the position at the end of the day, they may find that prices did not reverse and seem likely to continue to decline, in which case they may decide to maintain their position in hopes of a recovery in the days to come, or they may decide to sell at a price lower than expected.

    As you point out, we are in the market with other imperfect, irrational human beings. We can’t make somebody give us the price we want when we want it. Panics happen but they are usually reversed. We need to take appropriate steps to try to avoid participating in the downside.

    • Ben commented on Aug 28

      Agreed. It’s not necessarily that stop loss orders are a bad thing, it’s just that you have to know how to use them. As you point out a limit stop loss would have made a lot more sense here.

      • Brooklyn Bum commented on Aug 28

        Except when you put these things in you’re not expecting a flash crash. You should ALWAYS put a stop limit in – never a plain stop. You should ALWAYS have a price that below which reflects liquidity problems and is a no-go zone to avoid disaster. Stop orders are best reserved with traders with high leverage that trade quickly live and die by the sword. Not some joe schmo who buys an ETF. We will likely see a lot more of these unfortunate stories in the next year or two.

    • James Yaworski, CFA commented on Aug 28

      I’ll never understand the logic of a stop loss position. The flash crash should have been enough of a lesson for everyone on the dangers of the ‘strategy’.

      You own Stock XYZ at $100, and you apparently are bullish on the position since you’re long. So if it quickly moves to $90 you no longer love it? You’re bullish at $100 and bearish at a 10% discount, regardless of the reason? You don’t want to assess the reason for being down, you’re just selling. All that matters is that the price has gone down and that’s all the information you need to make the decision. Down 10%? Yup, now overvalued. Why? Doesn’t matter, sell sell sell!

      If you’re worried about a major event, like earnings, just follow the stock and sell if you’re disappointed by the news. After you’ve had a chance to reassess the fundamentals and determine if the stock is now overvalued, then make a decision.

      The only argument I can understand is if the advisor is going to be somewhere without access to the internet and won’t have the ability to understand why the positions are moving and therefore would rather be in cash than down big. Outside of a scenario like that, stop-loss orders are just laziness on the part of the advisor. Or the advisor has allowed his book to accumulate so many positions that he can’t follow everything his clients own, which is a mistake in its own right.

      • Steve commented on Aug 28

        Stop losses are also stop gains

      • Brooklyn Bum commented on Aug 28

        if i had to guess, in this example (based on his comment) it is pure naivete. Markets should be more liquid? Yeah, and when you looked at the charts that flash crash was a solid long bar and must have traded all the way down. lol. And you should be slimmer with a thick head of hair, but you’re not. It is the product of a fed supported perma bull market where everybody wins that seems to last forever. Is it really all that much different than Chinese with 4th grade eduction mortgaging their house into the stock market?

    • Brooklyn Bum commented on Aug 28

      stop orders were much better back in the day of human markets, but even then if you were stupid enough (for example) to put in a stop loss order 30 years ago in the bond pits before nonfarm payrolls you were still an idiot. 1987 anyone? Just because there are order types does not mean they work as you dreamt at all times. All fast markets have pockets of air where nothing exists – then, now, always. When a freight train takes out all bids or offers…. why would you want a market order to go live? Answer: you don’t, you are just a stupid white suburban kid who walked into the ghetto and became chum for sharks. Why bother to walk the streets if you don’t have any street smarts? There is one born every minute. And the market needs to purge these idiots more now than ever. It always does eventually.

  3. | commented on Aug 28

    […] Stocks set for bumpy end to wild week – CNN/Money The ETF Flash Crash – Wealth of Common Sense Oil Rally Is Biggest In Six Years: Short Covering, Anyone? – […]

  4. Friday Morning Links | commented on Aug 28

    […] Stocks set for bumpy end to wild week – CNN/Money The ETF Flash Crash – Wealth of Common Sense Oil Rally Is Biggest In Six Years: Short Covering, Anyone? – […]

  5. russellsawatsky commented on Aug 28

    I’m surprised that the financial advisor seemed to have been caught unaware of the potential outcome of his stop loss order. No order is without one risk or the other. You have to be aware of those risks and then just “choose your poison.”

    • Ben commented on Aug 28

      Right, there are always unintended consequences to these things when you don’t understand the market dynamics.

    • Brooklyn Bum commented on Aug 28

      financial advisors, life insurance salesmen, stockbrokers. its all beauty school level qualifications, which is why its flooded with idiots. the tests are a joke. this is not medical school. Heck, it is probably 100x harder to become a licensed massage therapist in NYC than become a “financial advisor”. Land of the free! Experience in the markets ONLY comes from experience, and this knucklehead just got an edumacation. Hey, as professional traders we all have gotten our hat handed to us – its the only way you learn. Hopefully it was his own money and not his client. A sell stop is a market order – and the crazy thing is that we have been through how many flash crashes??? You can’t save idiots from themselves BUT you *should* be able to save them from other people….

  6. James Yaworski, CFA commented on Aug 28

    Three things…

    1. How many ‘robo-advisor’ clients were down 20-30% monday morning and feeling helpless when they reached a call center that had no idea what was going on? I called Vanguard that morning and their product specialists couldn’t even explain it. I’m sure there were plenty of portfolios built entirely with ETFs that saw some pretty significant moves. Powershares S&P 500 ETF was down almost 40%, thats the worst I saw.

    2. In light of an event like that, I would certainly be willing to pay the slightly higher management fee in the mutual fund version of some of these ETFs. Vanguard has their ETF VOO, but I’d gladly pay an extra 0.10% for VFINX

    3. This will occur in fixed income ETFs one day, and that story will end differently. Does anyone really think there should be minute by minute liquidity in JNK? Some of those underlying bonds are lucky to be trading once per week, let alone multiple times a minute.

    • Ben commented on Aug 28

      I have a feeling a few more events like this and many investors are going to start considering the ETF/mutual fund swap, but the ETF growth is going to continue so investors have to get used to something like this as a possibility. Agreed that it could definitely happen to bond ETFs as well.

  7. Steve commented on Aug 28

    ETFs are Derrivatives. Most Advisors would get that question wrong on an exam… Most do not really understand them. Lots of salesmen, few really understand the elements of investing….

    • Brooklyn Bum commented on Aug 28

      if an etf is a derivative then a mutual fund is a derivative. that is not a very helpful observation, as if derivatives are toxic sludge that any individual investor should avoid. If you trade the S&P futures or ETF you are much more liquid and safe than the potential for a fat finger / flash flash etc in any single security. But, hey believe everything you read. In fact, if you know how take the correct amount of risk S&P futures and like to take profits from time to time the S&P futures actually ave a tax break in them (Sec.1256 contracts – 60% LT capital gains for short term profits). Markets crash whether its cash or derivative. AAPL traded at 92. Get over it.

  8. David_Merkel commented on Aug 29

    Instead of a stop loss order, before the volatility started, at my broker, I had alarms set for a variety of levels on different positions. Instead of creating automatic orders, when the alarms were triggered, I went out using limit orders to now accomplish the ends that my clients desired.

    Market orders are dangerous. If you use them you get what you deserve. Cramer may be a wild man, but he has been saying that for over a decade — don’t use market orders, use limit orders.

    • Ben commented on Aug 29

      Agreed. This is one of the reasons I think it’s so important to keep covering the basics every once and a while. People want to skip the simple steps and go right into the complex stuff.

  9. Keith G commented on Aug 29

    My thinking when I saw both $USMV and $VIG down 30%, something had blown up and it was a great time to try and buy. Unfortunately, I couldn’t get through to my Vanguard account through my phone app. I guess the Vanguard Servers were overloaded. Otherwise, I was just a spectator for the past couple weeks.

    • Ben commented on Aug 29

      I heard there were a few different places that experienced web difficulties. Pretty crazy stuff in those first 15 minutes or so. And nothing wrong with being a spectator most of the time.