Do you use Stop Losses – investors be warned

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• Do you use Stop Losses
• investors be warned

• The perils of Stop Losses
• Author Hari Swaminathan

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About OptionTiger

• On a morning like today, when the SPX gaps down
  17 points by the time we wake up in the United
  States, due to any number of concerns in Europe
  or Asia, the first thought that may come to an
  investors mind is How is my portfolio going to
  be affected ? And the second thought may seem to
  be comforting if youve set up Stop Losses for
  your stocks. But this is a false sense of
  comfort.
•  
• I had written an earlier post a few years ago,
  reflecting on the events of the infamous Flash
  Crash day and what exactly happened on that day.
  That post is replicated here, and provides some
  deep insights into how Stop Losses work, and why
  investors should not take comfort in Stop Losses.
  Most importantly, youll always hear money
  managers tout the use of Stop Losses as some
  perfect loss prevention mechanism. In reality, it
  is anything but. Take a read on what happened on
  Flash Crash day and what happened to investors
  who had places Stop Loss orders. This post below
  is from a couple years ago.

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About OptionTiger

• The topic of Stop Losses and Flash Crashes is
  back in the news. On Friday, Indias
  National Stock Exchange (NSE) experienced a flash
  crash that took the NIFTY 50 Index down 16 in an
  instant. Most stocks in the Index experienced
  crashes of between 15 and 20. Circuit breakers
  that were supposed to be triggered at a 10 drop
  did not work, and they ultimately kicked in after
  a few minutes when the index had dropped 16.
  Markets were halted, systems were reset and when
  it opened again, the Index recovered most of its
  losses but ended in the red for the day, but well
  off its lows. Read the full Bloomberg article
  here.

Sound familiar ? This is exactly what happened
on May 6, 2010 in the US. The SP 500 crashed
over 10 but recovered most of its losses, all in
about 20 minutes time. Just like the US incident,
fat fingers typing erroneous Futures orders in
the billions rather than the millions are
blamed in the Indian incident as well. With one
difference while we still dont know what
really happened in the US after 2 years, the
culprit was identified almost immediately in
India. The broker responsible for the erroneous
order  (Emkay Global Financial Services) was
immediately sequestered, all their orders closed
out, and their license to operate in the Indian
markets was revoked on the same day. Talk about
being judge, jury and meting out swift punishment.
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About OptionTiger

• But I want to focus on one very important issue
  about Flash Crashes and Stop Losses. Most
  investors including institutional investors use
  Stop Losses to prevent any further loss when your
  stock price drops. The way this works is you put
  a Stop Loss order and leave that order open with
  a status of Good till Cancelled. This order
  remains open in your account until you explicitly
  cancel it or until it gets executed.

The concept itself makes a lot of sense if you
want to protect your position beyond a certain
point, put your Stop Loss at that point, and you
dont have to worry about it after that. But is
this really the truth ? And what happens when you
have a Flash Crash ? Lets see what happened in
the US in 2010, and what must have surely
happened in India as well on Friday.
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About OptionTiger

• To understand what happened, we need to
  understand the Stop Loss order in a little bit of
  detail. When a Stop Loss gets triggered, your
  order is automatically converted into a Market
  Order. In a Market Order, your stock gets sold
  at whatever price the market is quoting at that
  particular point in time, as reflected by the Bid
  and Ask prices. Herein lies the problem,and its
  a very big problem. In the middle of a Flash
  Crash, the Bid and Ask prices are tumbling
  instantly and prices are crashing but no orders
  are being executed at this time. But your order
  is a market order, so its designed to execute
  whatever price the market allows it to execute.
  And in a Flash crash, this execution can happen
  at a price that is significantly lower that your
  Stop Loss point.

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About OptionTiger

• Lets use an example. You own Google (GOOG)
  stock. GOOG price is 770, and you (or your money
  manager) has a Stop Loss order at 700. If the
  price of GOOG falls to 700, your Stop Loss order
  gets converted into a Market order and your stock
  will be sold in the market. In an orderly market,
  you can expect to sell GOOG at very close to 700,
  perhaps 698 or certainly at 695. But in a Flash
  Crash, the Bid and Ask prices are tumbling
  without any executions. So GOOG could go down to
  600 or even 500, and at whatever point the market
  gets an opportunity to sell your stock, it will.
  This is exactly what happened in the US markets
  in 2010, and many investors got wiped out because
  these Stop-Loss-orders turned into Market orders
  and sold stock at the lowest possible point. To
  add insult to injury, the Flash Crash then
  recovers and GOOG makes it all the way back up
  along with the rest of the market and may end up
  at 740 for the day. Still in the red, but well
  off its lows. But to your dismay, your position
  was closed out at 500 only to see the stock
  bounce back up to 740. If thats not a Royal
  Shaft, I dont know what is.

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About OptionTiger

• The sad part is financial advisors and wealth
  managers tout the use of Stop Losses as a risk
  control mechanism. Next time you hear that, ask
  them how their Stop Losses worked on May 6, 2010.
  And if you do use Stop Losses, use a Stop Limit
  Order. This would work something like this
  your GOOG Stop Loss is at 700, but you
  also specify a Stop Limit at say 690. This means
  that your order will execute only between a price
  range of 690 to 700. If GOOG falls below 690,
  your order will not execute, and you can save
  yourself a ton of agony. Read these articles to
  find out what really happened to investors on May
  6, 2010.
•  http//seekingalpha.com/article/205009-stop-loss
  -orders-and-the-flash-crash-a-false-sense-of-secur
  ity
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• Heres an attorney who will represent you for
  losses from Stop Losses during a Flash Crash.
• http//www.crarybuchanan.com/Law-Blog/2012/April/
  Flash-Crash-and-Stop-Loss-Orders.aspx
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• http//online.wsj.com/article/SB10001424052748703
  950804575242942496526282.html 

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