Takeaways From the May 6th Flash Crash

 |  Includes: ACN, IVW, IWF, PG, VO
by: The Market Flash

I have seen many articles discussing the various possible causes of the May 6th flash crash. The purpose of this article is to share some thoughts with you, the retail investor, about how you should react to the flash crash in your personal trading and investing.

First of all, why was the May 6th flash crash something you need to be concerned about in your investing? May 6th was a volatile down day. The down day part is not news. In the fall of 2008 there were many days when the Dow changed 500 points or more in a day (mostly down).

What was important about May 6th was that for about an hour the recorded prices of major important stocks and ETFs on major exchanges were very volatile, sometimes showing recorded trades at fractions of a cent per share.

Here are some stocks and ETFs whose recorded trades occurred at prices below 1% of the “normal” (and May 6th closing price): ACN (Accenture), PG (Procter & Gamble), IWF (iShares Russell 1000 Growth ETF), VO (Vanguard Mid Cap ETF), IVW (S&P 500 Growth Index ).

Below are some suggestions about how a typical retail investor should consider changing how they trade and what kind of orders they use to trade in response to this flash crash.

1) Understand what a “market” order is at your online broker and when to use a “market” order. A market order says to your online broker to buy or sell the stock at the best price they can get for you. With a “market” order, you are trusting your broker to buy or sell your stock at the best fair market value on your behalf at a particular point in time.

On May 6th some “market” orders got executed at fractions of a penny. 99.9% of the time a market order is fine. I have made hundreds of trades at “market” and have been happy with all of them except one special case which I will discuss below. But the May 6th flash crash means that you now have to be careful not to make “market” orders when a flash crash situation is occurring.

First of all, let’s make sure we recognize a “market” order at an online broker when we see it. Below are screens shots of the Fidelity and Schwab trading platforms with a trade that would have gotten you in trouble around 2:40 pm on May 6th, an order to sell 1000 shares of Accenture at “market”:

This is the “market” order on the Fideilty trading platform:

This is the “market” order on the Schwab trading platform (click to enlarge):

Click to enlarge

If you don’t know what a market order looks like at your online broker, call their help desk and have them show it to you.

You may be reading all this and decide that you don’t want to make “market” orders anymore, which is fine. I personally am not willing to give up “market” orders so quickly. I don’t enjoy watching every little tick of the stock and then having to pick a price and put in a limit order to sell a stock. Then the stock moves down after you put your limit order in, and you didn’t sell, and you have to put in another limit order.

So here are two rough rules of thumb that will tell you when it is safe to make a “market” order:

1) The major indices (Dow, S&P, Nasdaq) don’t move more than 1% the day you want to make the trade. Boring days are ok to make “market” orders.

2) You look at the major online news sources and there are NOT stories talking about the stock market. If CNN.com, USAToday.com, and FoxNews.com do NOT have news about big moves in the stock market in their main sections that usually talk about the foibles of movie stars and international incidents, it is probably ok to make a “market” order.

The one time I was unhappy with a “market” order was when I put in the market order after the markets were closed. I was not pleased with the execution that occurred the next morning. It is a good idea to put your orders in when the market is open and there has been order flow already occurring and this is true in general, not just in response to a flash crash. If you think you have information after hours that makes you want to change your position (and keep in mind that it is probably information known by others), the best thing to do is login when the market is first open and put in limit orders.

Sell orders are more likely to have problems with flash crash failures than buy orders. That said, there was some time on May 6th when Accenture and Procter & Gamble moved up 20 points in a few minutes, and that would be risky for a person trying to buy.

2) Re-evaluate the stop loss and long term limit orders in your portfolio.

Most retail investors were not trading during the one hour May 6 flash crash. Where significant numbers of retail investors did get burned on May 6th was stop loss orders. In order to understand why stop loss orders got tripped on May 6th, let’s think like a computer.

How a computer would think: The price of Accenture just went below 35, this customer has a stop loss at 35. I have 1,432 other customers who have tripped stop loss orders for Accenture and now I need to sell 254,200 shares at “market” to fill all those stop loss orders.

How a human would think: Wow, Accenture just went below 35. I’ve never seen the Dow drop that fast, maybe this is some kind of technical glitch. I’m going to hold off on this trade until I see what is going on.

So the computers did their thing with the limited input they had and a lot of retail investors were tripped out of their positions (some at less than a penny a share, although these were later reversed) and by the end of the day the stock had recovered to above where their stop loss order was.

Another type of order used by retail investors is a long term buy limit order. Some people say “I don’t want the stock at the current level but if it was 20% lower I would want to own it”. So they put in a buy limit order somewhere below the current price of the stock. If these orders were executed during the flash crash, the buyers were generally better off, but the volatility is unnerving for some.

Online brokers have made stop loss and limit orders much easier to request and manage over the last 10 years. The flash crash means you have to look at the stop loss and long term limit orders in your portfolio. One should use fewer stop loss orders and perhaps more buy limit orders if you like risk and like to go stock fishing, potentially at below market prices. A stop loss puts a “market” order in if it gets tripped and that is dangerous in this new flash crash world.

It is unfortunate that retail investors have a new unknown to deal with in their trading. If you want to understand better what happened on May 6th, I found this Seeking Alpha article helpful and the author knowledgeable. I think clearly some important technical change in the market was made in the last year that has made these flash crash situations possible. Given that it is unclear when this flash crash situation will occur again, this article gives you some ideas to minimize the impact of a flash crash on your personal portfolio. If we have a period of 3 years where we don’t see a flash crash again, we can then assume that the exchanges have fixed the problem and we don’t have to take these defensive actions.

Disclosure: The author is long ACN