Yesterday marked the first anniversary of the flash crash. During the afternoon of May 6, 2010, U.S. stock prices plunged in a matter of minutes. The sudden downward move caused stop orders for many stocks to be executed, leaving some shareholders with unanticipated losses or realized capital gains. The events of that afternoon brought to the surface a few important points for individual investors.
The first is the involvement of high-frequency trading firms. Though their existence was known to professional traders and money managers, these firms were not in the public spotlight. Their ability to trade quickly has increased the speed at which breaking news is priced into the market. This arguably makes the market more efficient, especially for securities with higher levels of trading volume. It also makes day trading even more risky for individual investors than it previously was.
A second point is that how you place an order matters greatly. Investors who had standing orders to sell a stock or exchange-traded fund (ETF) if it fell below a certain price learned the risks of such orders on May 6, 2010. As Chris Nagy of TD Ameritrade explains in the new issue of the AAII Journal, a stop order turns into a market order once triggered if more specific instructions are not given. During the flash crash, prices fell rapidly and many orders were executed at what turned out to be artificially low prices. (Some of the trades were later cancelled.)
An alternative to a plain stop order is a stop-limit order, which includes a minimum price at which you want to sell the stock. This is not without risk either, as a stock could fall below the minimum price you want to sell at without your order being executed. Put options (a contract to sell the stock at a future date) lock in a sell price, but increase costs, especially since they expire worthless if not executed.
As you can see, even actions intended to provide downside protection to your portfolio are not without risk. Therefore, you need to weigh your desire to sell a stock or ETF as soon as the price drops to a certain point versus your willingness to wait until you are able access your account and asses the price action and news. (Investors who did not place stop orders saw their portfolios mostly unaffected by the flash crash.) If you do use stop orders, consider that events like the flash crash are rare.
The third point is that technology is a double-edged sword. Electronic trading has shortened settlement times, lowered bid-ask prices for frequently traded stocks, reduced brokerage costs and improved the flow of information. On the other hand, the stock and futures markets are now more interconnected, which means fluctuations in one market can influence the other market. Furthermore, when something does go haywire, the speed at which traders react is vastly accelerated. It is difficult for regulators to keep up with technological and market changes, especially since problems can be unforeseen, as was the case with the flash crash.
Regulators have been taking steps to prevent another flash crash from occurring. The latest idea is a proposal to institute a “limit up-limit down” system that would pause trading in stocks that move beyond a band based on transaction prices for the previous five-minute period. As I said last month, I think this should help, though any new regulation always has the potential for unintended consequences.
It is important to note that the markets do function normally the overwhelming majority of the time. There will always be systematic risks (the chance of losing money by simply participating in the financial markets), whether due to market gyrations or other, very infrequent events such as the flash crash. However, there is also a risk to not investing at all.
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