Korean Flash Crash Shows Perils of Out-of-Hours Trading

This strange semiconductor summer continues.

The stocks of chipmakers have been exceptionally volatile in the slightly lighter volumes of July and August. They’ve generally sold down — except for when they rally massively.

SK Hynix (SKHY) (KR:000660) is the poster child of this phenomenon. The excessive leverage taken out by retail traders in South Korea, and now to a lesser degree on Wall Street, leads to forced selling or buying whenever we get a significant move in either direction.

Flash Crash in Pre-Market Trade

This Asian morning, Hynix shares suffered a flash crash, trading down the daily limit in South Korea of 30%. That would ordinarily force the suspension of trade in the stock.

But the trade didn’t come on the Korea Exchange, where a variety of trading circuit breakers pause particularly volatile trading. The trade was for just 11 shares on Nextrade, which launched in March last year as an alternative exchange to allow out-of-hours trading in Korean stocks.

The investor who placed the trade was clearly alarmed by the forward guidance from memory-product makers Sandisk (SNDK) and Western Digital (WDC) when they reported earnings after the bell Wednesday on Wall Street, which would have been 5:30 a.m. in Seoul. The investor figured to get out ahead of the market.

Nextrade features trading from 8 a.m. to 8:50 a.m. in Seoul, prior to the start of normal Korea Exchange trade at 9 a.m., and after the 3:30 p.m. close until 8 p.m.

The total deal created a Nextrade low for the day — at 1,168,000 won — that was well below Thursday’s subsequent “actual” low on the Korea Exchange — of 1,481,000 won — with regular trading producing a loss of 10.4%. Hynix shares closed just shy of their “regular” low at 1,495,000 won. Down hard, but certainly not 30% …

A $256 Billion Paper Loss From a $9,030 Trade

The volume of the pre-market trade, at exactly 500,000 won below the prior day’s close, equates to just $9,030. So a trade of less than $10,000 created a 30% on-paper loss, shedding $256 billion in Hynix market value. Today, the company closes Korean trade with a current market capitalization of $789 billion.

The small pre-market Nextrade trade set the tone for a downward day for the Korean market as a whole. When full trading started, the Korea Exchange paused trade for five minutes at 10:18 a.m., after futures on the Kospi 200 index fell more than 5%.

The trading halts did at least stem the tide. The Kospi ended down 4.6%, more or less where it stood when the trading halt kicked in.

New System to Address Issue

It is not the first time we’ve seen a flash crash in Hynix shares on Nextrade. A similar 30% selloff occurred last Tuesday. While Thursday’s premarket trading ended with a slim 2% loss, to see shares change hands well below the last close certainly sets the tone for a downward day’s trade once the Korea Exchange kicks in.

Flash crashes also threaten to force program trades in derivatives based off Hynix stock. Bloomberg reports that Thursday’s trade forced the closure, within two minutes, of almost $60 million in long positions by holders of a derivative contract, trading on a cryptocurrency exchange but tied to Hynix stock.

Nextrade says it will introduce a mechanism to stop such divergent trades. As of September 14, it will have a system in place to trigger a two-minute price-discovery auction if there are trading bids at least 10% above or below the prior close.

Crazy Volatility

We have seen wild swings in semiconductor shares just in “normal” trading. Hynix shares lost 14.6% on July 28 alone, then rallied the maximum 30% allowed in one day’s trade on July 31, on the main exchange.

To see a major company, currently ranked No. 19 globally in terms of market size, gain or lose almost one-third of its value in a single day is extreme, to put it politely. We might simply call that level of volatility crazy.

The introduction, on May 27, of 16 leveraged single-stock exchange-traded funds (ETFs) based off the shares of Hynix and Samsung Electronics (KR:005930) have ended up amplifying single-day moves. The ETFs provide leveraged 2x exposure, 14 of them on the long side and two on the short side, and at times now account for as much as half of the daily trading in Seoul for Hynix and Samsung. There are now also five leveraged ETFs listed in the United States trading U.S. Hynix shares.

Retail investors say they are making and losing fortunes almost instantly. While Hynix shares have doubled this year, up 120.8% year to date, they are also down by half, off 48.8%, since their all-time closing high on June 22.

Once a highly leveraged stock starts moving strongly in either direction, the leverage is forcing through a series of margin-call and stop-loss trades on the downside, or program buying followed by a Fear of Missing Out feeding frenzy if the stock starts moving higher.

While institutional investors may be able to ride out a large selldown, retail investors are sometimes forced to liquidate positions at a leveraged loss that they can ill afford.

U.S. Shares Still Trading at Massive Premium

We also have the bizarre situation that the U.S. shares of Hynix are trading at a massive premium to their Korean counterparts. The American Depository Shares (ADRs) are changing hands today at a 36.6% premium, a phenomenon I explore in this story, because the Korean shares are not yet easily convertible into their U.S. counterparts.

That gap will presumably close as the U.S. and Korean shares become easier to exchange. In theory, they would create upward pressure on the Korean share price and downward pressure on the U.S. stock.

Chip-foundry market-share leader Taiwan Semiconductor Manufacturing Co. (TSM) (TW:2330) has been trading on both sides of the Pacific since 1997. The U.S. ADRs are changing hands today at a 12.7% premium compared to the Taiwan close. There will always be a premium for U.S. investors to trade the U.S. shares on home soil, removing the currency-exchange variance and allowing trade during “normal” U.S. hours. So we could expect Hynix to narrow the gap to something similar.

Pre-U.S. trade Thursday, the newly listed U.S. shares of Hynix were set to shed 6.7%, and in the earliest going have recovered to a 2.9% loss, faring far better than during the conventional Korean trading day. We can therefore expect a large leap higher in Korea Friday.

Sandisk shares were down 12.8% in early U.S. going, and Western Digital was off 17.9%, although both are trimming their losses, with Sandisk down just 2.7% and Western Digital off 8.9% as I file this story. Despite outperforming on earnings, we’re seeing the pattern that any disappointment on forward guidance gets punished. Sandisk is guiding for earnings of $44-$46 per share on revenue of $10.3 billion to $10.8 billion, just behind the analyst expectations of $44.72 on $10.82 billion in sales.

Western Digital is perhaps being particularly harshly punished since its earnings and guidance are in line with market expectations. But this summer’s rotation out of high-growth semiconductor stocks and into other market sectors continues … leading to sharp selloffs if the memory companies are just meeting expectations.

It at least makes sense for stocks to trade when the forward guidance changes. We can see from the Korean moves that earnings ripples can make a splash for other stocks in the sector.

At the time of publication, McMillan had no positions in any securities mentioned.