3 Important Lessons From The ETF Flash Crash

By Neena Mishra of Zacks Investment Research

Wednesday, September 9, 2015 5:16 PM EDT

The US stock market saw extreme volatility on Monday, August 24th, with some crazy trading after market open. Many stocks declined sharply and many ETFs fell 20% or more and some as much as 30%-45%, even though their underlying stocks had not declined so much.

ETFs are baskets of securities and they usually trade close to the aggregate value of their holdings. Significant dislocations from their NAVs are rather unusual for ETFs. However that morning, large dislocations in ETFs’ prices were seen not only in smaller ETFs but in some very large and popular ETFs as well. While these discrepancies lasted only for a short period of time, none of the trades executed during that time were canceled.

There were many factors that caused ETFs’ pricing problems. To begin with, NYSE invoked rule 48 at the open, which in simple words meant that designated market makers did not have to disseminate indicative prices before the open. The rule was meant to ensure a faster and more orderly open.

Then due to excessive volatility, many stocks and ETFs were halted for trading. Per WSJ, nearly 80% of about 1,300 trading suspensions were for ETFs. Total trading halts reported on Monday were almost 40 times the daily average this year.

Further, many stocks listed on the NYSE did not start trading for more than 10 minutes while BATS and NASDAQ exchanges started trading at the open. In other words, many ETFs were trading while their underlying stocks were not.

A combination of all these factors made it difficult for market-makers in ETFs to determine the right price for underlying assets and price ETFs accordingly. This caused them to price ETFs with very wide bid-ask spreads or just stay away from the market, since they did not want to take on too much risk when arriving at fair prices was so difficult.

There were some important takeaways for investors from extreme volatility seen that day. First of all, investors should not try to sell in panic; they should plan and then act accordingly. They should stay focused on their long-term investing goals. And most importantly, investors should remember to use “limit orders” in volatile markets.

To learn more, please watch the short video below:

Video Length: 00:08:51