Understanding ETF ‘Flash Crashes’

August 24, 2016

[Editor's note: This originally ran on Aug. 26, 2015]

 

The most useful part of the “Hitchhiker’s Guide to the Galaxy,” according to the novel by the late Douglas Adams, is that it has the words “Don’t Panic” written on the cover in large friendly letters. ETF investors would do well to take those words to heart.

Monday, dozens of ETFs traded well below fair value in the morning, and yesterday, pundits and reporters were scrambling to extract proximal causes and juicy headlines from the chaos. I spent Monday staring at tapes and reviewing timelines, and here’s what I think: The market did exactly what it’s designed to do, what it was told to do and what it’s been regulated to do. If you find that slightly scary, well, maybe you should … and maybe you shouldn’t.

My poster child for Monday’s craziness is the Guggenheim Equal Weight S&P 500 ETF (RSP). I pick this ETF for a few reasons. First, it was one of the stocks most heavily hit in the May 2010 “flash crash,” but second, I like to imagine if I were a market maker or an engineer designing trading algorithms, it’d be an easy mark.

It’s liquid—more than 1 million shares a day trade hands—but not so liquid that there’s no opportunity to arbitrage out price differences or make money on the spread. Its underlying securities are ridiculously easy to trade, and in a worst-case scenario, you can hedge any RSP position with any S&P 500 derivative or ETF and for a short period of time and get pretty close.

RSP got hit hard Monday, before it recovered, trading below $50 when “fair value” for the underlying stocks never dropped below $71:

So what happened? Well let’s go in time-series order here.

Pre-Opening

On a normal day, the designated market makers at the NYSE fire pre-opening indications of where they intend to start making a market—what their best bid and offer are going to be. Because of the chaos of Friday’s trading, the NYSE opted to invoke the rarely used “Rule 48.” Rule 48 effectively lets the designated market makers not tell anyone where things are going to open until they start trading, removing a level of information from the market.

Remember, not every trade must go through the market maker, and not every trade must go through the exchange. So before the open, we had bids and asks being put up on Nasdaq in the range of $70.50 to buy, and $74.19 to sell—a very wide opening spread that implies to me that the market makers were either waiting for the dust to settle, or very nervous about the opening trade.

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