Looks Like Somebody Got Killed on This Trade

Liquidity alert: If it's dead dry, think twice before you buy

Barclays Wins $4 Billion Lehman Clash As Court Spurns Appeal

The Barclays Capital building in New York.

Photographer: Andrew Harrer/Bloomberg

Guess what's crushing it in the world of exchange-traded products right now: the Barclays Return on Disability ETN. It has risen 77 percent so far this year, outstripping all others. 

And it trades four shares a day. 

How is that possible? It started with a bizarre trade made last month that serves as a lesson for investors: Know the product you're trading and look for red flags.

The investor here scooped up 100 shares of the ETN, whose ticker is RODI, on July 20 at $84.97 a share—even though the shares were worth only $55.27, based on RODI's net asset value, or the value of its underlying securities. Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) trade all day on an exchange, like a stock or bond, but they are themselves made up of many stocks or bonds on which their net asset value is based. RODI's price return is 76.7 percent this year, thanks to this trade. Meanwhile, its net asset value return is 6.3 percent. 

RODI, whose primary listing is on the New York Stock Exchange, tracks the stocks of the companies it deems best at hiring and working with people with disabilities. This is an honorable theme, so it's even harder to see somebody get hosed for trying to invest in it. The investor should have paid about $5,600 for the 100 shares but wound up paying about $8,500.

We don't know who bought these shares. Or how. But the 50 percent premium he or she paid and the small number of shares purchased suggest it was probably an individual investor unaware of the risks of buying and selling a thinly traded security—perhaps someone more accustomed to trading mutual funds. 

In any case, there were red flags all over this one. It bears repeating: RODI's average 30-day trading volume is four shares a day. Not 4,000,000. Not 4,000. Four. Which in mandarin sounds like the word for death.  

It will be difficult, if not impossible, to find a buyer for the shares at anywhere near $85, because what happened on July 20 was a perfect storm:

The investor almost certainly used a market order

That's an order to buy or sell a security at the best available current price, whatever it may be. A market order places a priority on speed, and can work well for securities that trade a lot. If there are many potential buyers and sellers citing a wide variety of prices at which they will buy or sell a security, that competition will usually keep the gap between the bid and asked prices fairly narrow. Thinly traded securities are another story. 

It was a thinly traded security with a bid/ask spread you could drive a truck through

Issuers of exchange-traded products typically make sure there's a market maker for their product — a firm responsible for providing liquidity to the market for a security so it can trade — before they launch. For very thinly traded securities, the market maker will set the quotes for what it would buy a security for (the bid) and what it would sell it for (the ask) farther apart from each other than usual. Market makers profit on the bid-ask spread and seek to minimize their risk in case this static market suddenly moves while they're attending to more dynamic shares.   

The bid-ask spread is in the blue box, while the executed trade is in the red box.
The bid-ask spread is in the blue box, while the executed trade is in the red box.

In the case of RODI, the average bid-ask spread during a normal trading day is about $5.50. That itself is astronomical compared to the asset-weighted average spread of five cents for all ETFs. Tragically, it still looks like a good deal compared to the $57 spread this investor traded into. That was just crazy.

So how did that happen?

The order came in outside of market hours

Before leaving work for the day, the market maker will typically widen its quotes to account for any big surprises overnight. Once trading starts the next morning, and everything seems in order, the quotes narrow. 

Right before the market opened that fateful Monday, the bid on RODI was $28.33 and the ask was $84.97 — there's your  $57 spread. When the investor put in that market order sometime over the weekend, it did what it was supposed to do: It went and found the lowest possible ask price come Monday morning. Problem is, that price was $84.97.  

So: If you have a hankering for a thinly traded ETF or ETN, consider using a limit order to buy it at no more than price X, which could be based on the net asset value, or perhaps a little more. That gives you total control. Your order may not get filled, but then you can raise the limit order a bit and try again. 

In this case, the investor could have checked the net asset value of RODI (on a variety of public websites, including Barclays'), which was about $56 at the time of the trade, and inched up in stages, given the light activity in the market. 

Know the product you're trading and the market you're trading in. Look out for the red flags. Consider your options. And don't be a vampire — trade during trading hours unless there's a good reason not to.

(Eric Balchunas is a senior ETF analyst at Bloomberg.) 

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