Global equity markets have experienced considerable volatility over the past year, and the situation has only worsened in 2016. Major indexes like NASDAQ and the Dow Jones have fallen more than 7% and 5%, respectively, so far this year. In this backdrop of falling oil prices and economic weakness in China, among others, turmoil in equity markets will likely continue in the near term.
Recently, such turmoil has driven massive sell-offs. Aug 24, 2015, the day, which many termed as “Black Monday”, rattled equity markets across the globe. Major equity indexes slumped 3−5% in pre-market trading, and nearly $1.2 trillion of the U.S. market value was wiped away by the steep sell-off. Exchange traded funds (“ETF”) were among the worst victims, with nearly 20% of the U.S.-listed exchange traded products experiencing trading halts during the session.
While analyzing the causes of disrupted trading on Aug 24, the U.S. Securities and Exchange Commission, ETF issuer BlackRock Inc (BLK - Free Report) and the New York Stock Exchange (NYSE) identified stop-loss orders as the primary culprit.
Notably, a stop-loss order helps an investor minimize her losses by triggering an automatic sell of a stock after its price hits a pre-set level. However, once such order is triggered, a stop-loss order behaves like a market order, and sells a stock at the immediately available price. According to Blackrock, a stop-loss order “seeks liquidity at any price”, which in turn, worsens the extent of sell-offs.
Nonetheless, analysts at various U.S. brokerage firms believe they can prevent another fast sell-off by revamping trading procedures, including the change of order types.
For instance, the NYSE, owned by Intercontinental Exchange Inc, no longer accepts stop-loss orders. Further, Wells Fargo & Company (WFC - Free Report) has reportedly incorporated an early-warning system that “interrupts brokers and advisers trying to enter stop-loss orders”. Additionally, while placing a stop-loss order on ETFs, closed-end funds and certain other securities, advisors at the company see a pop-up warning that "limit" order that could be processed only at a certain price or better.
According to people with knowledge about the matter, Bank of America Corporation’s (BAC - Free Report) Merrill Lynch unit is considering the ban of such orders altogether. Moreover, the company has been educating advisers on the use of limit orders. The Charles Schwab Corporation (SCHW - Free Report) , on the other hand, continues the use of stop-loss orders. However, it also continues to issue warnings about the associated risks.
If trading procedures at the top 4 wealth managers are revised as per the discussions, they will help lower the intensity of any future market rout. These include Wells Fargo, Merrill Lynch, Morgan Stanley (MS - Free Report) and UBS Group AG (UBS - Free Report) . Together, they constitute nearly 19% of the $2.2-trillion ETF industry in the U.S.
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