So, knowing where AAPL and GOOG are trading, the ETF market-maker sets his bid and offer in MGT such that he can try to trade AAPL and GOOG at a better price to offset his risk and capture a small profit. Since this position is fully hedged, he gets special capital treatment and can accumulate large inventory in the ETF if there's a large imbalance between natural buyers and sellers.
Now, imagine AAPL is halted. The ETF market-maker can't hedge his risk or have confidence in what the ETF is worth. At first, he updates his pricing to assume the worst (remember, this is a dumb risk-averse computer, maybe AAPL is halted because it's the next Enron) and bids a lower price. He can't get the same capital treatment on MGT hedged with GOOG or some other ETF, and this is a much risker trade, more of a statistical arbitrage than a pure one, so as people keep selling MGT to him, he hits a risk or capital limit and pulls his bids completely.
Real ETFs can have 100s of components. Since this is a mechanical process, high-speed market-makers can charge a very low spread and be the best bid or offer in the market almost all the time. They just trade 100s of ETFs at once to make it up in volume. This drives humans out of the market-making business, since human traders who did the same thing are undercut by machines. Because of this, few well-capitalized human traders are sitting around waiting to pounce on ETFs trading at a massive discount since it rarely happens. They're all doing something else with their lives.
A good solution would be not to allow market orders in ETFs when their component stocks are halted, or to halt trading in ETFs when the components are halted. Market stop orders should probably be banned in general. I can't think of any other business dealing where a person would walk into a store and say "I'll buy/sell this at any price", aside from buying lobster on a date.
In a fictional world, an envelope costs $1, a piece of paper costs $0.50, and a stamp costs $0.50. In total, a full letter costs $2. You know that anyone on the street would be willing to buy each of those items at the component price. Would you not agree that seeing all 3 sold as a bundle for $1 would be irrational?
Or that people are actually, as has been demonstrated in any number of ways, irrational. The idea that perceiving irrationality means there is something wrong with your world view rather than that there is actual irrationality in the world is somewhat odd.
But regardless, when you have a derivatively priced security like RSP (which holds actual stocks -- it has some inherent worth at all times that's knowable) any selling at a discount is supposed to be arbitraged away. In these cases, it wasn't,because the trading windows were too short.
(Hi, I'm the author of that blog post).
I assume you are referring to naked short selling.
To be clear, anyone may borrow shares and then sell them. Although legal ownership does pass to the borrower, this is not what most people think of if told they must "own shares prior to selling them".
In fact under SEC regulations, the borrow doesn't actually need to take place before the sale, so long as the broker has reasonable grounds to believe that the security can be borrowed to satisfy delivery for the sale.
From the retail traders perspective, this is typically transparent. They simply enter a sell order in a security that they don't own, and their broker worries about locating it for delivery (or doesn't allow the trade if it believes it can't locate the shares).
Until 10AM that day, the problem was zero buy-pressure. No bids at all to speak of.
http://www.etf.com/sites/default/files/images/2_rspsurveyor....
Also most high-frequency traders are market-makers or unofficially acting in that role. ISO orders are used by all executing brokers trying to sweep the best price, it's equally likely that the low sells were by funds executing stop loss orders through a brokerage or bank or wholesale market makers offsetting inventory at a loss after providing liquidity to retail stops.
Stock opens at X, you buy at 0.5X, you sell at 0.9X, it goes back to X. Then the exchange breaks the 0.5x trade. Now you still have to deliver the order you sold at 0.9x, but you're buying it at X, so you've earned a neat loss.
The rational thing to do is to get a cup of coffee. Unless you enjoy losing tons of money, in which case your idea is great as well.
If you believe the stock is worth a lot more than 0.5X and you're generally a buy-and-hold type investor, buy it at 0.5X and wait. If the exchange chooses to break the 0.5X trade it costs you only the opportunity cost of being able to buy something else at a good price during the next few days. And if they allow the trade, you got a great security for half price -- so you can be patient and sell at a later date, or hang on to the asset for whatever dividends it might pay out.
Yeah, this can't be overemphasized. When some widow or orphan (or more likely GS) is on the other side of the trade, then clearly it should be broken. Wouldn't want them to lose any money. /sarcasm
As you say, the rational action is not to play.
Other people have opined on this and said that, if the "clearly erroneous" rules are properly defined, then a trade should never never never be broken. It should simply not be allowed to go thru. That makes more sense to me.
Edit: And for those who think this is merely hypothetical, or just whinging, you should read this: http://www.ft.com/cms/s/0/37fff9c6-0b36-11e3-bffc-00144feabd... GS trades were broken. Hopefully the FT paywall won't block that link, it worked for me when I searched for the story. So who knows.
The rational action is not to attempt a short-term play. Having one side of your two-sided trade broken is a very bad outcome.
But if you're making a long-term play, that consideration is irrelevant. There's no "other side" of the trade for you to match up with. If you get an asset at 0.5X and then don't sell it and then the exchange breaks the trade, you get your money back and you're no worse off than when you started. But if you happen to grab an asset at 0.5X and the exchange doesn't break the trade, then you gained an asset for half of what it's worth. Now you've got a great asset in your portfolio, only you have twice as much as you should have been able to afford. That's a great move!