Diminished transparency at the start of the trading day and a slew of automated trade orders may have contributed to the steep plunge in exchange traded funds Monday morning before moving back in line once market makers stepped back in.
The New York Stock Exchange invoked Rule 48 in an attempt to prevent panic trading at the market open on Monday. The rule is typically invoked during extremely volatile market conditions and affects the ability of designated market makers to disseminate price indications before the opening bell. Stock market floor managers typically approve stock prices before trading begins, but with Rule 48 in effect, stock prices were not announced at the start so trading could get underway sooner.
However, with many stocks being halted shortly after opening Monday morning, the diminished transparency into prices may have affected market makers’ ability to calculate at what price to step in. Consequently, market makers stepped out of the way, allowing the market to price in orders before they were able to set their own prices, and waited for more precise numbers to come in.
Market makers are a major component in providing fluid exchange traded pricing. ETFs are traded on a primary market where market markers and the ETF sponsor help create and redeem ETF shares for underlying securities or holdings, which occur at the net asset value of the ETF, through so-called in-kind transactions. [How ETFs Are Traded]
Behind the scenes, the market maker would tap into the underlying benchmark to acquire the necessary liquidity to back the large ETF trade. The authorized participants or large institutional investors would swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
Without pricing clarity Monday morning as trading on some securities were halted, market makers were unable to accurately facilitate normal arbitrage opportunities between an ETF’s price and that of its underlying securities.
Additionally, the mini crash in ETFs may have been further exacerbated by automated stop-loss orders that immediately turned into open market orders. [Stop Order Drawbacks]
When purchasing or selling ETFs through a brokerage account, investors can choose among a various order types, such as a market order or a limit order. The options also apply to stop-loss orders that trigger an automatic sell when an ETF dips to a certain price. [Trading ETFs: Why Use Limit Orders]
However, investors should understand the differences between the order types. Specifically, a market order is designed to fill immediately at the best available current price and the price at which the order was placed is not guaranteed.
Consequently, once prices declined to a certain point on Monday morning, stop-loss orders were converted over to market orders to sell at the next available price. So, if someone had an open buy order at some obscenely lower price, the open market sellers would have been forced into even lower prices in what was perceived to market observers as a mini crash.
If investors took anything away from this experience, more people should utilize limit orders to help prevent a similarly unwanted run. A limit order is designed to fill at a specific price or better. A buy limit order would purchase the ETF at or below a stated price while a sell limit order will only be triggered at the stated limit price or higher.
While there is a chance that the markets could decline even further, investors should also try not to make things worse by allowing panic to dictate investment decisions. Long-term investors are better off staying patient and waiting for markets to calm.
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