Over the past couple of weeks, I have been focusing on the growing issue between passive investing and bloated ETFs… and I’ve gotten some great questions from readers who want to know more.
When this crash comes, whether it’s a ‘flash crash’ or far more serious, I want my readers to be prepared to rake in serious profits while everyone else is in freefall. And I’m happy to take the time to address your specific questions if that means you will all be ready.
If the coming crisis with ETFs is so obvious, why doesn’t anyone else seem to see it? –Anish
Good question! There are reasons hardly anyone is focusing on these very serious issues. Firstly, “out of sight out of mind”-people foolishly tend to believe that if it’s out of sight, it must have been fixed.
It’s frightening, but we never got an answer as to what caused the May 2010 flash crash. We recovered, and there was a lot of hand-wringing for a short while… then nothing. It’s like it never happened, or since we bounced right back it must not have been a big problem, or it was addressed and we don’t have to worry about it. This is just not true.
The same faulty logic applies to the August 24, 2015 market opening and then total flameout. Some stocks didn’t open, lots of ETFs couldn’t be priced, prices fell through cracks in floors no one knew existed, and stop orders got ripped through and filled substantially lower than investors expected. Was that all fixed? Heck no. But because it hasn’t happened again, people think it was figured out and fixed. NOT so. At all. It was just swept under the rug. So, if out of sight is out of mind, then why worry about something that’s thought to have been fixed?
Secondly, the growth of ETFs is so good for business, no one is willing to stop that train or stand in front of it. That includes ETF regulators. But putting your head in the sand can only last so long. Eventually you suffocate, and when you come up to see what the landscape looks like you may not recognize it. That’s what we’re going to see, one day soon.
Are there any ETFs that seem safer than the ones you mentioned, like SPY? Is there a way to passively invest without contributing to the crash you see coming? — Carol
No. None of them are safer than any others. As my dear mother used to say, “They’re all tarred with the same brush.”
The nature of ETFs – being derivatives of underlying stocks, which are often glued together as indexes – guarantees that any strong selling of the underlying issues will cause the derivatives to react. And it’s faster to sell the derivatives than all those individual underlying stocks, futures, or physicals. Selling ETFs themselves will be the principal weight initiating those feared negative feedback loops.
As a passive investor using ETFs, it’s impossible to avoid the trap. However, that does NOT mean you should stay away from ETFs altogether. All you have to do is understand what can happen and how to protect yourself. Play the game, play it to win. Understand how other players (the authorized participants, market-makers, and specialists) are playing the game and what they’ll do to profit from circuitous selling. Then get out of the way, or play the selloff to win big yourself.
Again, don’t sit on the sidelines because you’re afraid. Get in on the game now that you know the parameters. The money’s out there for the taking. Don’t let these professional ringers ring your neck – wink at them and beat them at their own game.
Does the same logic you used for what will happen with passively investing in ETFs apply to passively investing in mutual funds? — Steve B
Yes, unfortunately, the same logic applies. Mutual funds can’t sidestep a selloff or crash, it’s just not possible. The reason I’ll always have my hand in ETFs is because I can sell them throughout the day, pre-open, and even after the close sometimes. You’ll never be able to do that with mutual funds. If I see an ugly selloff coming, I’ll want out immediately.
The more money you save on the way down, the more money you have to invest after the dust settles.
Thank you for the useful insights in your email “The Perfect Portfolio Strategy for These Markets”. You covered the topic of put selling. What’s the best strategy to sell put options? Would you sell puts when the stock is in the oversold condition to sell the put or sell the put when the stock is in the overbought condition? If you sell in the overbought condition you get less premium so that doesn’t seem to be a good strategy… And then, if you sell the put in the oversold condition, you get higher premium but you could just buy the stock outright. Would appreciate some guidance here! — John B
These are all excellent questions. However, to answer them for you would take a whole lot of explanation about options pricing in terms of time, interest rates, and volatility, and about oversold and overbought conditions, how to determine what’s what there… That’s a LOT to address here.
My favorite book on options is still the first book on options I ever read, Options as a Strategic Investment by Lawrence McMillan. You’ll find most of the answers you’re looking for in there.
How soon after an IPO launches can you short it or buy puts? I know they have to offer options, but is there a general rule of when it happens? — Patrick
According to NASDAQ , “Options on a stock may be listed, at the earliest, seven business days following the IPO. Once an IPO is listed on a national market, stock options may be listed, provided that the IPO meets certain standards.”
These standards include:
- A stock float greater than 7 million
- More than 2,000 shareholders
- Five consecutive days during which the closing price is at least $3.00 on the primary listed market
You can use some of the information in an IPO’s prospectus to determine whether a stock will likely meet options-listing requirements. The prospectus will list financial information for the company, facts about the deal, and the risks of investing in the company, among other details.
As far as shorting an IPO, technically, you can short an IPO on the opening day. The problem with shorting an IPO is you have to be able to locate shares you can borrow to “deliver” to the buyer you are shorting/selling to. If you can’t locate and borrow shares, you can’t deliver them to the buyer on settlement date, and that’s a no-no. Underwriters are forbidden from lending out shares for 30 days. However, retail investors and institutional investors who own shares have them, and the brokerages that hold their shares can technically lend them out to facilitate short-sellers.