This is from a recent posting at Interactive Brokers, in answer to an email. Thought it was pretty entertaining.
Q: Dear IB Management, When will IB get with the program and give us trailing stops? CYBER Corp (now Cyber Trader) and other direct access brokers do.
A: We believe that trailing stops are a controversial issue and we are opposed to them for the following reason.
Trailing stops are liquidating orders placed simultaneously with an opening order. The stop price is a set amount away from the price at which the position is entered into and it moves penny for penny with the stock price as long as the stock price moves in favor of the position. Once the stock price reverses by the amount set in the trailing stop order, the position is liquidated.
It is a method of trading that, taken to its ultimate conclusion by a large number of followers, would ruin its practitioners, their carrying brokers and wreak havoc in the market with potentially dangerous repercussions for the economy.
Trailing stops are akin to "portfolio insurance", generally recognized as the reason behind the large downward spiral of the crash of 87. Both strategies are based upon the illusion of a liquid market with price continuity for any size at any time. A stop order turns into a market order when activated and market orders must be executed immediately at the best available price, no matter what the price may be. When using stop orders, the price will gap to the next available quoted price or limit order and the next stop order will be executed at this price. It should be clear that when many trailing stop orders are active on the same instrument, they will potentially all generate market orders at around the same time, independent of when and at what price they were originally placed.
Let us now consider the imaginary scenario in which the NASDAQ 100 index as represented by the QQQ reaches and penetrates a widely recognized chart point in its relentless upward march. The penetration of the chart point is a signal to thousands of technologically well equipped traders to jump on the bandwagon by issuing orders to buy Qs at market with a trailing stop of say 20 to 200 cents under the subsequent high. As they pile in, the price shoots up, convincing momentum traders to follow. These traders also want to protect against losses, while enjoying the gains as long as the momentum carries the Qs and will want to use trailing stops.
The price continues to climb as the traders watch their profit accumulate and issue additional buy orders, thinking that their gains are protected by their trailing stop orders. The only suppliers of Qs to the market are market makers and arbitrageurs who buy baskets full of NASDAQ 100 stocks to hedge their sales. As their buys of the baskets pushes up the prices of the underlying stocks, those stocks begin to attract additional momentum or chart point users with their trailing stops.
Everybody plays, everybody wins.
The Qs finish the day with an 18% advance, a new record, attracting some profit takers the next morning. This profit taking causes a slight reversal, maybe only 20 cents, triggering a few of the closely set trailing stops. The resulting market orders from the first few trailing stop orders, hitting out ever lower resting bids, activate the trailing stops set to go off at successively larger reversals, generate more and more market orders to sell.
But there are no buyers. The offer prices falls down further without any bids in sight. The avalanche of sell orders in a cascading market activates a temporary trading halt, but the selling cannot be stopped. A long list of electronic sell orders are waiting in the pipe line to be executed at any price.
Longs, expecting to be closed out 20 to 200 cents under the highs, get executed at 10, 20 or 30 dollars lower than their stop price. Margin accounts undergo forced liquidations along with bank loans collateralized with listed equities. The President reassures all of us that the FED stands ready... etc.
This exaggerated, but possible, scenario can be applied to a small group of traders trading a single stock, with much smaller but similar effects.
Trailing stops bunch all the stop orders near the same price level, resulting in a rush of market orders all at the same time, causing a gap in the stock price.
Using trailing stops works only as long as only a few people do it, and they are not concentrating on the same instruments.
Interactive Brokers serves professional investors and traders. We provide our customers with sophisticated tools that will aid them in earning a profit and fulfilling an economically useful function.
A facility for trailing stops is not such a tool. It will generate large commission income for the brokers who provide it, but on the long run, the customers of these brokers will loose their money and it will destabilize the market.
- Thomas Peterffy, Chairman, Interactive Brokers Group (06/29/2001) |
