On May 6, the stock market went into a sudden and surprising decline. Millions of investors were caught by off guard. While the events of that day are being passed off as an anomaly in the markets, there are important lessons in them that advisors can learn.
Outside of the “flash crash” free-fall, the markets have been acting efficiently. But during that 20-minute decline, something obviously went terribly wrong. As a result, many of the trades that were executed in that span have been canceled. Three-fourths of those canceled trades were for ETFs.
There are many unanswered questions about that day and the Securities and Exchange Commission is still digging for clues.
The SEC has said that, so far, the exact cause of the flash crash has not been found, but that in general a few things may have contributed:
- Traders stepped back and refused to either buy or sell stocks and futures.
- The SEC also discovered a reliance on automated sell orders at the market price.
- There are different rules on different exchanges about when trading is automatically slowed or stopped.
1. “Good ‘Til Canceled” Orders. Many investors were burned by “good ‘til canceled” orders. GTC orders are orders to buy or sell when the security reaches a set price. It’s in place until the investor cancels it or the trade is executed. Those who placed GTC order had those sell orders triggered at the market price, resulting in sells way below the actual market price.
For example, if a stock is trading at $50 and you have a GTC order to sell at $40 and the stock drops to $38, the stock is then sold at the current price of $38 – not $40. This is, in effect, placing a market order and it guarantees the trade will go through, but it does not guarantee the price at which it goes through.
2. Don’t Panic. Many of the sells may have been from panic sellers who placed market orders as everyone was heading for the exits. Up and down markets don’t make anyone feel good. It’s in these kinds of markets where a strategy becomes more crucial than ever. What we saw during the flash crash was likely fueled by a lot of emotional panic selling, and if you panicked, you got hurt.
3. Market Orders vs. Limit Orders. Many market participants were burned by market orders, rather than placing limit orders and controlling the price they paid. Market orders are orders to buy or sell at the current price, no matter what the price may be. Having a limit order in place puts the control back into your hands by letting you set the price at which you’re willing to buy or sell. If that price isn’t there, then the order won’t go through.
4. Staying On Top of Things. Try to cogitate before placing stop-loss orders on ETFs, put limits on them, and update them if holdings rise in price. Stay well informed and know what you’re getting yourself into. Advisors should know about the dangers of relying on automated trades. Be careful with computer-generated stop-loss orders that sell a position when a security hits a certain price.
Circuit Breakers In Place
The SEC has implemented temporary circuit breakers on all S&P 500 stocks in an attempt to prevent similar occurrences in the future.
The system works like this: The circuit breakers will pause trading in those stocks for five minutes if the price moves by 10% or more in a five-minute period. The circuit breakers will apply both to rising and falling stock prices.
The circuit breakers will help control any unfair trading and keep electronic trading platforms moving smoothly. SEC Chairwoman Mary Shapiro has suggested that the growth of electronic trading, which in some cases makes it possible to execute trades of thousands of shares a second, could be putting investors at a disadvantage.
The new circuit breakers are on a trial basis, which will run through Dec. 10, 2010.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.