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Market Commentary > The Little Guy Didn’t Have A Chance

The Little Guy Didn’t Have A Chance

2015-09-17 Leave a Comment
Bart Chilton is the former commissioner of the US Commodity Futures Trading Commission. Last Friday on CNN, he said the market situation on Monday, August 24, 2015, brought to light a major issue that individual investors face but are often unaware of—liquidity. This is just one more unfair advantage that institutional investors have over individual (retail) investors.

The August 24 market correction will go down as one of the worst trading days in Wall Street's history. In fact, trading was halted on individual stocks and exchange traded funds (ETFs) about 1,200 times. This is serious stuff, so let me explain what that means. The markets have two mechanisms in place to limit trading when there is extreme volatility in the markets. These "circuit breakers" exist to prevent trading on either a single security outside of a specific price band, or marketwide, to halt trading for a specified period of time if at any point during the trading day, the markets decline by a certain percentage based on the prior day's closing price of the S&P 500. These circuit breakers are designed to limit the whipsawing, or wild swings in the markets and when triggered, in essence, it gives the markets a “timeout.”

But these timeouts can affect both individual stocks and ETFs because unlike most mutual funds that only trade at the market close, ETFs are baskets of stocks and bonds that trade all day long, and therefore an ETF's price can fluctuate throughout the day.

Ok, bear with me here. ETFs are a very popular investment vehicle, so let's talk why the August 24 volatility had such a significant impact on many of them. The value of an ETF is determined by calculating the weighted average of whatever assets it owns. This value is commonly referred to as the Indicated Value (IV). While the actual price of an ETF can trade a little bit above or below the IV, it usually doesn't vary from the IV by too much.

Nevertheless, problems can arise when trading is halted on one of the underlying stocks held in the ETF (as a result of the circuit breakers on individual securities). If that is the case, then how do you price a basket of stocks when one of its components isn't actually being offered to trade in the markets? And how do you offer for sale a basket of stocks if any of those stocks are not being traded, at least temporarily? Those are the problems that the retail investor was facing on August 24 and will continue to face.

You see, the institutional investor did not have to face the same problems. Let me introduce you to Wall Street's “market makers.”

The market maker, is a company or individual that quotes both a buy and a sell price on an asset, hoping to make a profit on the bid-offer spread.

A market maker will usually hold an asset and then find a seller, and thus assumes some of the risk of the asset devaluing. To compensate for this risk, they will offer slightly different prices to different buyers and make tiny profits on thousands of trades. These firms tend to be responsible for providing an orderly market in the equity world.

Market makers also can provide liquidity for an ETF that otherwise is not liquid. This is because some market makers are also authorized participants.

Only authorized participants are permitted to either create or redeem units of an ETF. When creation takes place, an authorized participant assembles the required portfolio of underlying assets and turns that basket over to the ETF in exchange for newly created ETF shares. Similarly, for redemptions, authorized participants return ETF shares to the fund and receive the basket consisting of the underlying portfolio.

If the underlying securities are trading at a lower price than the ETF shares, these market makers may buy the underlying securities, redeem them for creation units and then sell the ETF shares on the open market for a profit. If underlying securities are trading at higher values than the ETF shares, they may buy ETF shares on the open market, form creation units, redeem them to get the underlying securities, and then sell the securities on the open market for a profit.

As you might imagine, market makers, who often set the bid and ask price of ETFs, do not operate for the benefit of the individual investor.

The individual/retail investor is at the mercy of the markets—the prices available on the retail markets are the only prices available to that investor.

So, let's take ourselves back to that August 24 market. Take a minute and relive the panic of that Monday morning. China had its biggest selloff since 2007, Australia had its biggest crash since 2009, and Europe was in the toilet. Most of us were on edge as the opening bell approached and we saw the Dow futures fall 1,000 points, instantly.

When the bell rang, the sell orders exploded. It looked like everything was trading in the red. In fact, stocks were “halted” or “timed out” before they even started trading, making the valuation of ETFs all but impossible.

So, market makers did what they always do. They offered to sell shares at very high prices, while offering to buy shares at exceptionally low prices.

Many who accepted those offers on the retail market were taken to the cleaners.

But here's the catch, by simply bidding at very low prices, market makers all but guaranteed that some clients would sell. The reason is because stop-loss orders, which are very common on the retail platform, were in place. Retail investors often set stop-loss orders, standing orders to sell if the price falls below a certain threshold, usually at 10 or 20 percent below their purchase price. By creating stop-loss orders, investors don't need to watch markets all day long or try to get an order in when things are moving quickly. When a stock or ETF hits the stop-loss price or below, it sells at the highest bid—no matter how low it is.

Well, on August 24, the market makers had simply set their spread at impossibly wide values, offering to sell well above the indicated value, while offering to buy back shares well below.

From one standpoint, this makes sense, right? Think about it, the market makers had just as much reason to fear further declines as anyone else.

So retail investors sold many ETFs at very low prices, to market makers, who immediately resold the shares at a much higher price. The loss to the retail client—and the gain to the market makers—was locked in.

If you had owned one of the more common ETFs, the Vanguard Consumer Staples, it fell 32 percent that Monday morning, while the actual IV of that ETF fell a mere 9 percent. How's that for a well-functioning market?

On the other hand, things happened a bit differently for the institutional investor. Institutional investors can negotiate with market makers to minimize downside risk by negotiating to sell at a specific price, so even if the prices keep dropping, that negotiated price is locked in.

I know, stop-loss orders can be written with a limit, such as offering to sell a stock if the price falls by 10 percent, but limiting the sale to -15 percent. But seriously, why should a retail investor be unable to sell their shares in an ETF when the price drops by 10 percent, particularly if the IV has not dropped even that much?

Look, the point I am making is that this is just one more way that the retail investor bears greater risk than the institutional investor. When it comes to execution prices, no group takes a bigger risk, and incurs bigger losses, than individual retail investors.

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The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by radical promoting and their editorial staff based on the original articles written by jeff cutter in the falmouth enterprise. This article has been rewritten for Rick Durkeeand the readers of Rick's Weekly. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

 
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