3 Reminders For When Trading Halts

How investors should react to marketwide trading halts.

Thursday morning's session opened with a 15-minute trading halt after a 7% slide in the S&P 500 index triggered the Level 1 marketwide circuit breaker. This is the second such marketwide trading halt this week (read: "How Trading Halts Impact ETFs").

Additionally, trading in Dow and S&P 500 futures was briefly halted overnight, after they hit their 5% "limit down" threshold.

Among retail and professional investors, the trading halts have done little to soothe rattled nerves. Some market commentators have even begun to propose more extreme measures to protect the stock market, such as an immediate Fed rate cut to zero or an extended trading holiday.

It's easy to let the panic take over. But in such volatile times, there are a few things to remember.

Trading Halts: Safety Valve, Not Hull Breach

First of all, circuit breakers do not exist to stop or prevent the stock market from falling. Rather, their function is to institute a marketwide “time out,” ensuring that price discovery remains intact and buyers and sellers can still execute their trades.

Since volatility can beget volatility, the idea is that a 15-minute trading halt gives investors in the market a chance to take a deep breath and reevaluate. That's particularly important given that so many trades nowadays are generated by computer algorithms, automatically instigated by specific market moves, and executed in millisecond time frames.

There are three levels of circuit breakers. We already saw the "Level 1" version trip this morning, when the S&P 500 Index dropped 7% from its previous day's price. If the benchmark continues to slide to 13% from the previous price, then a "Level 2" circuit breaker will trip, kick-starting another 15-minute halt. At a 20% slide, the "Level 3" circuit breaker trips, and trading is ceased for the rest of the day.

We've never hit either the Level 2 or Level 3 breaker. Until this point, we've never needed to. And while anything still can happen, it seems that today, the Level 1 circuit breaker once again did its job: When markets reopened, individual stocks and ETFs still declined, but overall market volatility had cooled substantially.

Never Sell ‘No Matter The Cost’

For most buy-and-hold investors, the best course of action in volatile times is usually to take no action at all. But let's be realistic. Most of you are probably planning to buy or sell right now, whether to seize upon buying opportunities, harvest tax losses and benefits, or even just indulge in some good old fashioned speculation. These next two reminders are for you.

Investors often fixate on expense ratio as the ultimate gauge of an ETF's cost, but it's not the only cost that matters—nor is it the only cost you have control over. Trading costs are important, too.

Most widely used ETF trading platforms now have some version of commission-free trading, so you won't have to worry about paying an additional price for order execution. However, volatile markets will widen ETF bid/ask spreads. It's not a question of if, but how much (read: "Understanding Spreads & Volume").

What's more, premiums and discounts to net asset value (NAV) can develop after a trading halt, especially when the fund's underlying securities become less liquid (due to, say, additional halts levied on individual securities) or there's a massive uptick in order flow, from everyone trying to place a trade at once (read: "Understanding Premiums & Discounts").

"If you feel you must sell [after a trading halt], wait an hour or two for pricing to settle down," tweeted Ryan Kirlin, head of capital markets for Alpha Architect.

Use Limit Orders

Limit orders should be standard ETF trading practice, but they're especially important in volatile times.

Unlike a market order, which is an order to buy or sell an ETF as soon as possible, a limit order only executes if the ETF's share price hits a prespecified price. A buy limit order for $5/share, for example, only goes through if the ETF hits $50 or below.

Market orders prioritize speed over price, which can be a seductive promise in times of heightened market volatility. But they can also lead to greater losses in selling, especially when the aforementioned widened spreads and/or discounts to NAV have developed.

On the other hand, limit orders set boundaries over a trade, to ensure you are never paying more or receiving less than you plan for. They can be a powerful tool of the disciplined investor (read: "ETF Education: Different Types Of Trades").

"'Use limit orders' is the 'wash your hands' of ETF trading," tweeted Ben Johnson, director of global ETF research for Morningstar.

Contact Lara Crigger at [email protected]