Stop-loss orders are supposed to protect investors when prices plunge, but during Thursday's market chaos, the strategy may have backfired horribly and contributed to the massive slide in stocks.
A stop-loss order instructs the broker to sell a stock or exchange-traded fund when the price falls below a certain level. But when the price level is breached, the order is automatically converted into a market-order, meaning the sale is executed at the best available price.
That's fine if the market is liquid and orderly, but when volumes are thin and prices are bouncing around violently, the sale may end up being executed at a ridiculously low price if that's the only bid on the books.
"I'm not suggesting I have exact knowledge that this is what happened, but stop-loss orders … can really cause you problems in these scenarios," said Steven Leong, vice-president of iShares product management for ETF provider BlackRock Asset Management Canada.
At least two iShares ETFs - the iShares Dow Jones Canada Select Dividend Index ETF and iShares S&P/TSX Capped REIT Index ETF - saw their unit prices plunge to well below the asset value of the underlying stocks. Some of the most egregious trades in the REIT ETF were cancelled.
Even worse, units in the Claymore Canadian Financial Monthly Income ETF briefly plunged to a penny. Those trades were also cancelled, but the gyrations made for a harrowing day for some retail investors.
"It was impossible to reverse my stop-loss sales by buying back at or below the stop price because the prices of some stocks recovered so fast," said one Calgary investor. "In any event, I couldn't get into [my discount brokerage account]as its website was overwhelmed, and of course, so were its phone operators."
"[It]cost me a lot of money, but I suspect that those who were able to get into the markets fast enough during the slam due to technological sophistication, luck, or a direct investing website that held up, were able to make a bucket full of money."
The Investment Industry Regulatory Organization of Canada also cancelled or re-priced trades that occurred between 2:40 p.m. and 3:10 p.m. in Fortis Inc. and Inter Pipeline Fund.
Mr. Leong said a combination of bad data, extreme market volatility and multiple trading platforms also contributed to the market mayhem. He said that prices bounced around depending on whether an order was routed through the Toronto Stock Exchange or through Alpha, the bank-owned alternative trading system.
Making matters worse, the volatility overwhelmed computer systems and resulted in inaccurate pricing data. Market makers - whose job is to keep an orderly and liquid market in ETFs - would have been unable to perform their function of buying and selling ETF units in such a chaotic environment.
"The best that we're going to be able to do is to piece it together based on looking at the tape and talking to some of the market makers," he said.
"I think it is a combination of market makers not being able to take on the risk of posting markets, combined with bad data interfering with routing technology … I'm not sure that we'll ever get to exactly what happened."