ETF Capital Markets Desk: Flash Crashes- Putting Out all the Stops

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    In a prior Capital Markets Corner blog, David Mann, our head of Capital Markets, Global ETFs, addressed the subject of flash crashes, and why trading during periods of heightened volatility differs from trading during periods of heightened uncertainty. Many investors employ so-called “stop-loss” tools, believing they can limit the downside in these circumstances, but as David explains, these tools can require careful handling.

    The flash crash of August 24, 2015, which saw global equity market volatility rapidly spike, has been widely analyzed and its causes debated, but many commentators agree that the situation may have been exacerbated by the widespread triggering of stop-loss orders as the volatility rose. Flash crashes are a modern phenomenon, a result in advancements in electronic trading, so it prompts a reexamination of trading best-practices. Stop-loss orders are typically used to automatically sell a security once it drops to a specified price level at some point in the future (which could be months). These orders can be helpful tools to limit losses in a particular security, but also come with some drawbacks.

    The main drawback stems from the fact that the order itself has no context as to the reason for the market’s move. For example, let’s say an investor bought an ETF at $100 and then entered a stop-loss order to sell if it reached $90. The order cannot tell the difference between an orderly market decline over a four-month period down to $90 from a “flash-crash” type drop to $90 that then immediately sees the market pop back up to $100. In both cases, the order is triggered and an order to sell is entered into the market.

    During the August flash crash, daily order volumes on The New York Stock Exchange were six times higher than in the prior month, and exchange-traded products saw an even greater level of volume.1 Many of these sale orders were the result of stop-loss orders reaching their trigger price. These sale orders flooded the market at a time of heightened volatility and lower liquidity, which exacerbated the price drops.

    It is worth taking a step back to acknowledge that there are two main types of stop-loss orders. The traditional stop-loss order turns into a market order to sell once the price has been triggered. As we have discussed in our trading best-practices, a market order seeks liquidity at any price. The other type is a stop-limit order, which works the exact same way, except that the order to sell has a “limit” price attached to it.

    Stop-limit orders sound better than stop-loss orders since there is a limit price. However, as noted above, this order also takes no account of what is happening in the market to trigger that order. Let’s go back to our example:

    Two investors buy an ETF at $100. The first puts in a stop-loss order to be triggered at $90. The second puts in a stop-limit order, which combines a stop-order triggered at $90 with a limit order to sell at $89. In an orderly market decline over several months, if the order is triggered, both investors should expect to sell their ETF somewhere around $90.

    Now let’s say there is a flash-crash type event where the ETF started at $100, dropped down to $82, and then bounced back to $100. The first investor would have his/her stop order turned into a market order to sell, which could be as low as $82 depending on the liquidity at that instant. The second investor would sell the ETF closer to $89 because of the limit price attached to it.

    However, the big takeaway is that BOTH INVESTORS SHOULD BE UNHAPPY! Why? The ETF bounced back to $100. I suppose the second investor would be a bit happier than the first, but they are both surely disappointed.

    I keep coming back to the spirit of the stop-loss order, which is to add discipline to the investment decision making process on securities that are declining in price. I am all for that kind of discipline, but no one says it has to be enacted with this specific order type. I would rather see some form of an alert (whether it’s an email, pop-up window, etc.) when the market hits the desired selling price. That will allow the investor to assess what is currently happening in the market. If it is indeed an orderly drop, then he or she can consider entering in a normal limit order to sell. If it is a flash-crash type of event, then he or she can watch from the sidelines and determine that best course of action based on his or her individual circumstances.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    This information is intended for US residents only.

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    1. Source: New York Stock Exchange, “Strengthening US Equity Market Structure to Better Address Extreme Volatility,” January 28, 2016.

    What are the risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.