Trader Talk

Stocks' dramatic slide hits ETFs

Ugly day for banks
Ugly day for banks

There were some dramatic drops in stock prices at the open on Monday. There were dramatic drops in prices of ETFs as well.

This is not surprising. ETF market makers base the price of ETFs on the liquidity and the pricing of the underlying constituents.

Many stocks Monday morning took several minutes to open. There was a very high level of uncertainty about what the price was of those underlying constituencies.

What happens when you have to open an ETF when, say, half of the stocks are not even open?

The market maker has to make certain assumptions. Every market maker has proprietary ways to price their ETFs, but it's not that mysterious. In the absence of a trade, they make a guess.

Remember, there was enormous selling at the open. The Dow dropped nearly 1,100 points in just five minutes.

No one has ever seen that kind of drop in five minutes. You are a market maker, and you now have to make a certain assumption about stocks that are not even open yet.

What will happen is this: ETF pricing is going to be very wide until there is certainty in the underlying prices.

And that is what happened on many ETFs. There was, for lack of a better word, "pricing havoc" in some of them.

Still, I saw some ETF trades that had scratching my head.

Take the S&P Dividend ETF , a basket of high-dividend paying stocks, such as Coke, Johnson & Johnson, Colgate.

It closed Friday around $75, opened at $70.45, and was immediately halted. When it reopened five minutes later, at 9:37, there were several trades at $46.22. It did eventually recover, but only when the market came back.

Wow, that is a big drop. And this was at a time when most of these stocks were likely open.

What is strange is that the bid was $59.62, the ask was $59.63 when this occurred.

If you are going to be a market maker, it would certainly seem to be a requirement to have a reasonable bid/ask spread.

I am not sure what happened here, but it's worth an inquiry.