ETF risk, Trading

Trading risk. The risks of trading ETFs in the stock market include high-frequency trading, large-volume trading, “circuit breaker rules”, and “shorting”.  Some ETFs may be an institution’s preferred vehicle for trading, in which case the fast trading of large volumes can increase market volatility.  A large sell-off of ETF shares possibly contributed to the May 6, 2010, “flash crash” of stock prices13,14,15.  The “circuit breaker rules” require stock exchanges to pause trading when there is a rapid, severe decline in market price.  The pause duration depends on the severity of decline and the time of the trading day16.  “Shorting” of either the underlying assets or ETF shares outstanding involves borrowing the assets, or shares, at market price, selling them at a different market price, and returning the borrowed assets, or shares, to the lender.  The lender charges a fee and the borrower (“short seller”) incurs a profit or loss.  A hidden risk of these activities is “failed trades” as evidenced by delayed or cancelled settlements.  ETFs may lend no more than a third of their underlying assets.  Mutual fund shares cannot be lent to short sellers17,18.

copyright © 2011, Douglas R. Knight

References

13.  SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.

14.  Choking the Recovery: And Unrecognized Risks Of Future Market Disruptions. Harold Bradley and Robert E. Litan. Published Nov. 8, 2010, revised Nov. 12, 2010.  © 2010 by the Ewing Marion Kauffman Foundation. All rights reserved.

15.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.

16.  Circuit Breakers and Other Market Volatility Procedures.   U.S. Securities and Exchange Commission, Modified: 08/09/2011.

17.  Ari L. Weinberg.  Exchange Traded Funds: When ETFs are LendersWall Street Journal, July 6, 2011.

18.  Canaries in the Coal Mine. Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.

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