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.
The Lessons
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.