New Rules For ETF Trading An Upgrade

August 23, 2013

Limit up/limit down is changing things for the better.

This week, ETF investors saw the effects of the phase II rollout of the limit-up/limit-down program (LULD). They needn’t worry—at least not as much as they think they should.

Despite the fact that trading halts in more than 50 ETFs and ETNs on Aug. 19 left investors worrying that something had gone awry in the markets once again, it was quite the opposite. Things worked exactly as they should have.

The idea of the new LULD system stems from the “flash crash” of May 6, 2010, after which it became clear there were significant issues needing to be addressed regarding market structure—especially during times of peak volatility.

After months of review and mulling through data, the Securities and Exchange Commission approved a national market system plan—limit up/limit down. The idea was to prevent problematic trades in individual exchange-traded securities by setting percentage price bands above and below the reference price of a security over the preceding five-minute period.

So how do the mechanics of the system actually work?

ETFs are covered under phase II rules of the program. Under the rule structure, price bands are constructed by applying a formula to the reference price of an ETF. The price band formula is fairly basic:

Price Band = (Reference Price) +/- [(Reference Price) x (Percentage Parameter)]

The percentage parameter is determined by the securities’ previous closing price, and under the LULD plan, most ETFs will have a percentage parameter of 10 percent.

Price Band

*For phase II securities, price bands are doubled during the first 15 minutes and last 25 minutes of the regular trading day.

However, it’s how that “reference price” is calculated that might be problematic for the program.

The reference price for securities is calculated using either the arithmetic mean price of the ETF over the last five minutes, or the midpoint of the opening quote of the ETF from its primary market listing.

The reference price is updated after 30 seconds only if a new reference price is at least 1 percent away from the current reference price.

This can and does become an issue for ETFs that don’t trade, because the reference price is entirely based on bid/ask quotes, which are often wide and may not change as much as quotes in actively traded ETFs.

So when do halts occur?


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