On the morning of August 24, 2015, Wayne Thorp walked into my office and asked if I had seen what was going on with the iShares Dow Jones U.S. ETF (IYY). I said something to the effect of, “I know the markets are down because of China, but what’s going on with IYY?” He responded, “It’s down by more than 20%!”

The price drop in the exchange-traded fund (ETF) was surprising because it is a broad-market index fund. The Dow Jones U.S. index tracks the largest 1,200 domestic stocks. On a morning when the S&P 500 index was down about 5%, this ETF should not have been trading 20% below its previous trading day’s close.

We found out later that the iShares Dow Jones U.S. ETF was far from alone that morning. Many ETFs and stocks [including widely held PepsiCo Inc. (PEP)] incurred temporary but steep price drops. Though I can’t say with certainty what happened, it appears to be due to a combination of events. An influx of sell orders prior to, at and shortly after the opening of trading made it difficult to price stocks. In response to the volatility, various circuit breakers—ironically intended to maintain orderly trading—kicked in. In turn, it suddenly became difficult to price ETFs, which diminished the role of institutional traders who use arbitrage strategies to keep the prices of ETFs close to that of their underlying assets.

As regulators investigate the occurrence further, we’ll know more about what happened. But right now, I can say simply that the process for executing buy and sell orders did not work as it should have.

Those who had no market orders in place to buy or sell stocks or equity-based funds that day were unaffected by the temporary problems. Those who attempted to trade on that morning, either intentionally or because stop orders were triggered, may have been stung by the rapid whipsawing that prices experienced.

Market orders are orders to transact at the best available price. The default setting on every online brokerage firm I’ve used is to place a market order. In a normally functioning market, market orders work well for large-cap stocks with high trading volume and very narrow differences between what buyers are bidding and sellers are asking (the bid-ask spread). These orders give you the greatest odds of completing your intended transaction, but don’t work well with stocks less frequently traded—such as the micro-cap stocks held in our Model Shadow Stock Portfolio—and don’t protect you against pricing problems like what occurred on August 24.

Market orders can be executed if a sudden price change causes a stop order to be triggered. A stop order is an instruction to the broker to execute the trade if the security or fund (ETF or closed-end fund) falls below (a stop loss) or rises above (a stop buy) a specified price. Once the stop is triggered, the order becomes a market order and will be executed at the best available prevailing price—even if the price only exists for a few seconds or minutes.

Limit orders and price alerts can protect you from such sharp market moves. Limit orders are instructions to transact only at certain prices—buy only at prices below $X or sell only at prices above $Y. They can also help reduce transaction costs when the bid-ask spread widens, as is often the case for shadow stocks. The downside of such limit orders is the risk of not having the order filled. Price alerts are simply notices that a security or fund has risen or fallen to a certain level. Alerts give you time to examine what is occurring before placing an open order.

The pricing problems on August 24 were symptomatic of a sudden drop in liquidity. Hildy and Stan Richelson discuss how liquidity can impact the price of ETFs, mutual funds and bonds here. In a forthcoming issue, we’ll delve into the structure of the stock market.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII

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