Use ETF Limit Orders, Stupid

May 06, 2011

A year after the "Flash Crash, it seems clearer than ever that limit orders are part of the solution.


It’s crazy to equate the widespread price dislocations of the flash crash of May 6, 2010 to what happened earlier this spring when 10 FocusShares ETFs and one iPath ETN briefly got unhinged from their net asset values. But there’s one exception that unites all these strange episodes.

The mayhem began in all these cases with market orders. All the craziness, ETFs being driven down to a penny or, in the case of the iPath Optimized Currency Carry ETN (NYSEArca: ICI), getting bid up to the sky, began with market orders.

So, when will all the folks who play in the ETF traffic wise up and stop using market orders – especially on illiquid securities -- and start using limit orders. And just as important, when will they start insisting, even requiring, that their clients do the same.

I shudder in my own boots when I think about the bullets I dodged during my stint as a broker at Smith Barney. I used market orders to buy more than a few ETFs on behalf of clients. Some of them were relatively new funds, meaning they didn’t trade on heavy volume, and were therefore vulnerable to the “blowthroughs” that happen in this era of electronic trading to both individual stocks and ETFs alike.

Overkill? Maybe so, but I’d say it’s better to be safe than sorry, because it doesn’t take long for things to go off the rails, and who needs to have that kind of conversation with a shell-shocked client? I’d rather tell the tale that we missed an accident because, with the limit order in place, in an instant the market blew right past what we considered to be a range of fair value.

On April 14, for example, it only took three minutes for iPath’s ETN, ICI, to shoot up to as high as $2,682.19 a share, according to Bloomberg data we looked at, before settling down to its fair value. It closed at $46.05 a share. The weirdness started at 1:10 p.m. and was over by 1:13 p.m.

Like a tornado, really, and who needs it, especially when it could all have been avoided by using a limit order?

And like tornadoes, there’s damage left behind. Sure, all the ridiculously off-market trades were canceled. But the threshold at or above which trades were cancelled was $48.74, or the better part of $3 over ICI’s closing price.

The ICI incident all stemmed from a market order that was way bigger than the ETN’s average daily trading volume of 7,000 shares.

The market went the other way on March 30, when 10 of 15 new ETFs from FocusShares went berserk, sending some of the funds’ prices down to a penny.

Hearing that an ETF again traded at a penny a share understandably dredged up memories of the flash crash. That’s grossly unfair, of course, because the FocusShares blowthrough occurred because the lead market maker apparently mispriced the underlying basket of securities.

During the flash crash, selling pressure was immense at a time when buyers and market makers were nowhere to be seen. While some ETFs did trade as low as a penny on that day, they were highly liquid securities, such as the Rydex S&P Equal Weight ETF (NYSEArca: RSP), a multi-billion-dollar fund that canvasses the S&P 500.

Conversely, the new FocusShares ETFs, on their second day of trade, were relatively illiquid. The same goes for iPath’s ICI, which didn’t have enough liquidity to hold up to the excessive orders that followed the large market order.

The anniversary of the flash crash, seems like the perfect occasion to call on the the exchanges and regulators to put their heads together to address the blowthrough issue.

I certainly don’t think market orders should be banned, but like ETF consultant Richard Keary argued in his column on IndexUniverse, maybe officials ought to come up with a liquidity minimum governing the use of market orders to help keep the price of ETFs and other securities in the realm of reality.

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