Summary What happens to some ETFs but not others and why. Managing the risk by using a pair trade. The key is increased market volatility. Introduction As I wrote a series of articles explaining how I created my own portfolio over a lifetime (including the lessons of both success and failure), I received question about how a flash crash occurs. This led me to include an article in the series explaining my understanding about how a flash crash gets started and how some stocks, and particularly some ETFs, end up with such exaggerated extremes during a flash crash. The explanation was very well received by readers. You can find the full article here . The discussion in the comments sections led me to consider how one might profit from the midst of panic. When the crowd is panicking someone is always finding a way to profit from the overreactions that occur. One reader commented that s/he intended to place a good until cancelled order to buy one of the ETFs that got hammered during the flash crash session of August 24, 2015. At first glance it seemed like a reasonable way to take advantage of the situation when the price of an ETF falls significantly below what one could reasonably expect to be the net asset value [NAV] of the underlying assets. But as I thought about it some more I decided there might be a negative catch involved called risk. It seemed like a relatively low risk trade at face value. You commit no funds unless the ETF falls precipitously and you get to buy at a price you otherwise would not believe possible. However, there is also a growing possibility that the next time this happens it could very well not be a flash crash but the beginning of a bear market. That is what I define as the potential risk involved in the trade. It is possible that the speculative trade (not to be confused with investing, which I define as long-term), could still yield a profit if the trader sold the position either near the close or early the next day once the price and NAV normalized. But, if the market falls into a bear market that begins with a waterfall formation of multiple gap-down trading sessions, the profit could disappear in just a few sessions, or even just hours, and not come back for months. My first rule of investing is to limit losses. So, I decided to consider alternative ways to reduce the risk of the trade and limit the potential loss. Before I continue, I want to explain that this is not something I look for on a regular basis. Those who have followed my work will know that I am generally a very conservative, long-term investor looking to increase the income from my portfolio over time. But, occasionally there appears a unique opportunity that I want to take advantage of that poses a relatively low-risk (or limited amount of risk) with a very high reward potential. This is one of those trading opportunities that I look at very infrequently. Also, I do not use very much capital on such a trade. There is no such thing as a sure thing. To limit risk I do two things in this instance: limit how much capital I put at risk to limit my potential loss; and make sure it is a trade that does not require me to guess the direction of the overall market trend. I know what you are thinking: a flash crash, by definition, means the direction of the market is down. But it does not necessarily define the overall trend. After the last two flash crashes (2010 and 2015) the market went higher in subsequent months. A flash crash can happen in either a bear market or a bull market. It is temporary, hence the “flash” component, lasting only a few minutes or hours, at most. Then stock prices snap back to near where prices were prior to the flash crash. This is just a strategy I plan to employ to take advantage of the next one. If you believe that the Federal Reserve and SEC have everything under control and that another flash crash will never occur, you should stop reading now. However, if you believe as I do that another flash crash is likely to occur sometime in the next year or two, then the potential profit from this strategy may make sense to you. What happens to some ETFs but not others and why I want to start with an illustration using the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP ) and the SPDR S&P 500 EFT (NYSEARCA: SPY ). As the saying goes, “A picture is worth a thousand words.” (click to enlarge) This chart represent hourly price activity for the two Indexes from opening on August 24, 2015 to the close on August 25th. Notice the range from the daily high to the daily low for RSP on August 24th, $75.57 to $43.77. Amazing, is it not? The range of the SPY was $197.48 to $182.40. The range for RSP was a staggering 42.1 percent while the range for a similar ETF, SPY, was only 7.6 percent. How could this happen, you may ask? After all, both ETFs hold the same stocks, components of the S&P 500 (^GSPC), although in two different weighting methods, so how could the prices vary so dramatically? The short answer is volume and liquidity. For the long version I will use an excerpt from my earlier article: Normally a market maker will keep the spread (difference between the bid and ask prices) narrowly around the NAV of the underlying assets of the fund. Under normal circumstances they will gladly buy the ETF for a little under the NAV and then sell it for a little more than the NAV when needed to keep shares trading efficiently. When trading in one of the stocks that make up the ETF is halted by an exchange, having hit its “limit” down as determined by the exchange, the market maker for that ETF must decide what the spread should be and place orders accordingly. Market makers are not in the business to lose money, so when they err it is always on the side of caution. In this case, not knowing what the NAV is (because trading in some stocks has been halted and when those stocks begin trading again the price may be different from when it was halted), the market maker most likely looked for price support levels in the stocks for which a value could not be determined and placed a bid to buy at an assumed NAV based upon those prices. When multiple stocks are halted at the same time, the market maker lowers the bid to make certain that a loss is not incurred. With the market falling so abruptly, the bids by the market makers were set significantly below actual (or the last known) NAV. Hopefully, that is clear enough to explain why some ETFs diverged significantly from the value of the underlying stocks that make up the funds. My best guess is that the market maker for RSP considered its position to contain more risk since it did not have the protection of the weighting for the stable companies at the top. Thus, when several of the stocks that make up the S&P experienced a halt in trading at the same time, especially when many of those issues were of lesser capitalization, the market maker simply chose a technical support level for those shares that it could expect to hold up and set a bid based upon the much lower assumed NAV. In addition, the HFTs, sensing a rout and recognizing a thinly traded ETF in RSP, probably hit the sell button with bids even lower and then probably cancelled those orders before being filled. The HFTs could then place buy orders even lower and pick up shares at deep discounts when there were no other bids if sellers placed market orders. The HFT trading systems are automated so there are rarely humans involved. The programs are set to identify unusual market activity and to predict potential outcomes. They place thousands of orders and can cancel within a few thousandths of a second with the objective to move the price. They move with incredible speed and usually take pennies or fractions of a penny from many thousands or millions of transaction per day. On August 24, 2015, I suspect some HFTs made chunks instead of pennies. Volatility is the friend of HFTs. Managing risk by using a pair trade It should be obvious that if an investor had the presence of mind to have bought shares of RSP when the price got distorted to the downside, s/he would have turned a nice profit. The problem, as I pointed out earlier, is that the next time the market drops like this it may actually be the beginning of a major bear market and the rebound may not be as strong. One way to tell, would be how long the share price of RSP remains extremely low compared to SPY and if the difference begins to narrow over the course of the trading session with SPY falling to reduce the gap over a matter of hours rather than minutes. If that happens my strategy will work even better. There are three ways to enter the trade and I will explain each one. Each has a different risk profile and a different potential return. There is the convenient entry plan, the actively managed entry plan, and the reactionary plan. I do not know which will work the best but have my expectations. I will try out each one and report back if/when we have another flash crash on how each alternative plan of entry worked out. The convenient plan requires me to buy an out-of-the-money put option contract on the SPY with a relatively near-term expiration, say January or March of 2016 with a strike of $185 (or about eight percent below the current market value). At the same time I want to place a limit order to buy 250 shares of RSP at a price of $50. The reason for using 250 shares instead of a round lot is to match the approximate values of the underlying equities represented by the 1 contract of SPY at a price of $185 to the expected ending value of RSP (about four percent below the current price) at about $72. I use four percent because that is the value at which both SPY and RSP fell by the close compared to the previous close during the August 2015 flash crash. The number of shares is also off a few shares but I am not trying to get a perfect balance or match, just a close approximation of similar values. I want both pieces of the trade to have similar values so that a one percent move in either index will make both positions of the underlying move about the same amount. If a flash crash happens on Monday (not expected but always possible), as long as it does not happen before I can enter my positions, I would be positioned to gain significantly from it. So, let’s do the math. In a flash crash, we expect both positions to end up near where we started, maybe a little lower. If both were to settle about four percent lower than the previous close, as happened on August 24, 2015, then RSP would generate a profit of $5,500, while the put on January SPY put option (costing me $150 + commission) might eke out a small gain of a couple hundred dollars or so. At the end of the day I would sell my RSP shares near the close for a gain of about 44 percent. The initial position in the SPY put option, assuming I use a January expiration contract would be about $150 ($1.50 x 100 = $150). This is all I would need until a flash crash actually happens. If RSP suddenly drops to $50 during a flash crash, my order should get filled and that end of the position would cost me $12,500 ($50 x $250 = $12,500). If a flash crash happens I will tie up $12,650 and expect a return of about $5,500. If it does not, I lose the $150. Then, when the January SPY put option is near expiration I can sell it or let it expire worthless (if SPY stays above the strike price, which is likely) and purchase another put option on SPY further out into the future. And then I wait again. This could require a lot of patience since the last two occurrences were over five years apart. If it takes that long again, I could be out $150 a month for 60 months, or $9,000. Buying puts that are expire further into the future could bring the monthly cost down but it would also require lowering the strike price to ensure the trade could be profitable. That changes the risk profile. It does not make much sense. So, the next step is to determine when to initiate the put option position and when to stay on the sidelines to lower the cost and keep the trade profitable. The Key is market volatility This is the hard part to identify. On the days preceding each flash crash there were at least one trading session that exhibited the trait for which I am watching. I want the ^GSPC to fall for the day more than the average daily movement of the preceding two weeks and close at or very near the low of the day. If you look at the charts below from May of 2010 and August of 2015 for both ^GSPC you will notice that within the two days prior to the flash crash, the index had a larger than average down day and closed at or near the low of the day. We will have some false positives along the way but this can reduce how long we are in the market with a put option and bearing the cost of a potentially worthless asset. The same pattern also occurred in both ETF charts. S&P 500 Index from 2010 S&P 500 chart from 2015 I would insert the charts but YCharts does not support bar graphs which are necessary for the illustration and Yahoo! Finance did not let me copy these images. It is clearer on the August 2015 chart, but remember that there are two components: size of the move and closing near the low. The size components is what weeds out most false positives. The second entry plan requires active management. As an alternative to leaving the put option open and letting it expire worthless, one could only buy the option when the set up occurs, hold it for a week or so and then sell it if nothing happens, incurring a much smaller potential loss (or maybe a gain from time to time) from each entry attempt. That is a lot of work, but it could potentially make the trade far more profitable than the convenient alternative. The third entry plan is the reactionary plan. This alternative requires us to just place the limit order to buy the shares of RSP and wait for the flash to start. Then buy the SPY put options about ten percent or more out of the money in the closest expiration month (be sure you are not within just a few days of expiration because you do not want to have the options executed). You will pay more for the options in this scenario but this is the one that makes the most sense to me. I do not want to leave the RSP order completely naked for very long, so if the market begins to fall precipitously I would buy the SPY puts no later than when then price of RSP falls below my order limit price of $50. In this instance, once we have both positions in place we are merely waiting for the prices of the two index ETFs to normalize as we have already locked in the profit defined by the spread between the values of the two positions. This alternative is likely to provide a one-day gain of 35 percent or more. It may never happen. But if the market just continues higher we never make an investment and have no capital at risk. The one big caveat that I need to make clear is that we need to keep an eye on the RSP share price. If the market begins to fall into a bear market without a flash crash it will be necessary to lower the limit order price on RSP. I plan to keep it at about 33-35 percent. In 2015, RSP fell 42.7 percent from the previous day’s closing price but then rebounded to close up 67.5 percent. In 2010, RSP fell 58.1 percent and rebounded 129.2 percent. I am not trying to be greedy and capture all of the move. I just want a reasonable piece out of the middle. Now let us look at the charts. May 2010 RSP chart May 2010 SPY chart Notice that SPY only fell 10.1 percent and rebounded almost 7.6 percent by the close on May 6, 2010. August 2015 RSP chart August 2015 SPY chart Here we see that SPY only fell 7.8 percent from the previous close at the bottom and rebounded by 3.9 percent on August 24, 2015. Conclusion We only want to capture the difference in movement between the two ETFs. It can be looked at as a spread, however, it is not a true spread since I use an option on one end and shares on the other. I do not, as a rule, sell shares short. I use options to hedge against downside risk and intend to use options to protect against the downside potential should the crash turn out to be more than just a flash in the pan, so to speak. Once I have the two positions filled, in the reactionary entry plan, I will profit. There is no doubt of that since the underlying assets will eventually revert back to NAV on both and the difference is very little between the two ETFs while the difference that I intend to lock in will be significant. We have only had two such occurrences to date. There may never be another. But I want to be prepared to enjoy that day if it does come again.