This is August! Markets Aren’t Usually This Strange..
While most of the country was sleeping at 3am Monday morning, August 24th 2015, the Chinese equity markets were just about to close. The benchmark composite, the Shanghai Composite, had fallen -8.49% on the day. Including the prior two trading sessions, the entire composite fell over -15%! The U.S. Futures market, relating much of the news around China, started to experience heavy volatility before the market opened on Monday.
Meanwhile, in Chicago, The VIX index value was increasing exponentially. The VIX Index is the Chicago Board Options Exchange Volatility Index, which measures a market estimate of future volatility based on the weighted average of the implied volatilities for a range of strike prices for options. On Monday morning, the VIX reached 54, a level not reached since late 2008 amidst the global recession. A normalized VIX value would be near 20. Seeing the potential for extremely high volatility surrounding securities, at around 9 am, exchange specialists at the New York Stock Exchange (NYSE) invoked Rule 48.
Rule 48, when invoked, stops exchange specialists from determining the opening price of a security. Normally, specialists at the NYSE receive indications of where a security will open, two to three minutes before the start of trading. This information, along with historical pricing and the activity in the futures market, helps specialists determine what the opening price of a security should be. Here’s the literature of Rule 48:
The purpose of Rule 48 is to allow for the quicker and easier opening of individual securities (theoretically). If the specialists are not formally pricing stocks, like with Rule 48, the market will essentially dictate the prices for them. The implied equity volatility pre-market for securities led specialists to believe that they would likely be unable price stocks accurately. Due to this volatility, specialists would rather let the market price the securities, theoretically delivering smoother price action for the beginning of the trading day.
On Monday morning, the S&P 500 eMini futures were halted from trading around 5 minutes before the market was even set to open. This was due to the volatility that the futures were experiencing, which caused a circuit breaker to kick in. The futures market, much like the regular stock market, has volatility limits that can halt trading for a certain amount of time. With the volatility in premarket trading and a large number of securities halted in early trading, it became incredibly difficult for market makers to make markets around securities during the first 15 minutes of trading.
Market makers are individuals who take information from both the exchange specialists and the data surrounding futures and create a “market” for securities to trade. They help set the spread between what the bid price and the offer price of any given security. Due to the lack of information, it became very difficult for market makers to create said “markets” for securities, causing bid/ask spreads to widen more than usual. For example, see chart below:
This is the trade blotter for the iShares S&P 500 Index ETF (ticker: IVV) from Monday morning. The left side indicates the time when the trade occurred. The Bid/Ask spread for IVV is usually only $0.01. After the market had been open for 16 seconds, the Bid/Ask spread for one of the most liquid securities in the world was just shy of $14 wide (squared in red)!
As the market was opening up, the downtrend in many stock prices caused stop-loss orders to be triggered. Stop-loss orders change to general market orders when the trading price falls to the stop-loss order’s indicated price, allowing for the original stop-loss order trade to be executed. Since many of these executions were above/below 5% of the prior execution, the “limit up/limit down” rule caused circuit breakers to kick in and halt trading of individual stocks. The 5% up/down rule came to fruition during the market “Flash Crash” of 2010. The “Limit Up/Limit Down” is a rule imposed to help suppress volatility surrounding a security by halting its ability to trade. If the price of the security trades either 5% higher or lower from the reference price, the security will be halted for a minimum of 5 minutes.
So how were ETFs affected? Well, for many ETFs, market makers were having difficulty pricing various ETFs, as many of their underlying securities were halted from trading. This also caused many ETFs to be halted from trading as well. According to BlackRock, the iShares MSCI USA Minimum Volatility ETF (USMV) was halted 8 times as the ETF price declined below the value of the underlying basket of securities. USMV was halted for a total of 40 minutes between 9:30am and 10:19am. By 10:20, the ETF resumed trading in line with the basket of underlying securities, as seen the graph below:
This graph represents the difference between USMV’s trading price and its corresponding Net Asset Value (NAV) during the timeframe that USMV was halted. The green line represents the price of the underlying basket, or NAV, while the white line represents the actual ETF price. While the Net Asset Value of USMV stuck true to its underlying securities, the ETFs price did not reflect the underlying value of its holdings. During the course of a normal trading day, if a single security is halted, an ETF owning that security would continue to trade around the halted security, eventually reflecting a price near the NAV of the underlying securities. It wasn’t until around 10:30am until the prices of ETFs more closely reflected their NAV.
An ETF’s price is usually reflective of its NAV due to market participant’s ability to exchange ETF shares for a basket of its underlying securities, or vice versa. For example, when the basket of securities can be purchased at a price lower than the indicated price of the ETF, market participants can buy the underlying holdings and exchange them for shares of the ETF (creating new shares of the ETF). Due to the ability to earn an arbitrage profit, the price of an ETF very closely tracks the value of its underlying holdings.
For investors who like to trade their own portfolios, we suggest two best practices for trading that aim to improve overall trade execution:
Moving forward, the events of August 24th are likely to spur another round of debate around financial market regulations. Monday’s events showcased that improvements to recent rules such as Rule 48 and the Limit up/down rule may be warranted. With the growing use of ETFs as investable vehicles, their market share is likely going to continue to grow. As such, old regulations will likely be updated and fine-tuned to protect investors of all sizes.
Until next time,
 NYSE Rules, Rule 48. Exemptive Relief – Extreme Market Volatility Condition.