The Dark Side of Stop Loss Orders
Richard Shaw
custom portfolio mgt
QVM Group Oct. 1, 2010
In the complete absence of major negative news, a diversified portfolio of investment grade corporate bonds has absolutely no fundamental or technical reason to decline by 10% on an overnight basis -- and if it did have reason, then there is no reason to recover the 10% loss in the next one minute. This is a pure and simple example of the failure of the currently constructed electronic trading systems to create and maintain a reasonably orderly market -- and a good example of why so many investors are frightened away. There is an urgent need for some kind of stabilizing, circuit-breaker algorithms per security to be built into the electronic system in the absence of human specialists
To our shock and dismay today, we had LQD positions in several accounts with stop loss trigger prices of approximately $109. Those positions were stopped at 9:31 AM at prices between $101.74 and $101.81. Those were huge losses equal to about 2.5 years of interest and substantially more than the losses that would have occurred with a sudden unexpected 2% interest rate increase.
To our extraordinary relief, Schwab (the broker we use), adjusted those trades. They couldn't reverse them -- we are still stopped, but they were able to establish a "bad print" and adjusted our execution price to levels we found quite satisfactory in the vicinity of the prices that prevailed in the minute after our stop.
So much for our tale of horror, and relief. The issue for you is to be aware of these electronic trading risks and pick the alternative that best suits you.
With some (perhaps many) brokers you have these choices;
1. do nothing -- buy and hold -- avoid whipsaws, but suffer the damage of the next "2008"
2. closely monitor price and use mental stops -- immune from electronic distortions, but exposed to emotional instead of rational exit decisions, and need for constant observation (no time off)
3. use technical stops -- removes emotional decisions, but you've got to be watching all the time (forget two week vacations)
4. use multiple criteria conditions for stops (e.g. Bid and Ask pierce trigger price) -- but those orders expire and new trailing stops cannot restore old set points
5. (at Schwab) use non-expiring "bracket" orders when opening a position -- automatic until you cancel order, but only based on Bid which sometimes collapses (as it did for LQD today)
Our problem today, was that we chose #5 for non-expiring protection, but were hit by collapsing Bids. You can bet we raised heck with Schwab suggesting that they should make the multiple conditions options available on bracket orders that they make available on approach #4 -- or, they should make the multiple conditions approach of #4 non-expiring, at least as an option. If you use both the Bid and the Ask as conditions, it is less likely that a instantaneously collapsing Bid would be accompanied by an instantaneously collapsing Ask.
f you have a short-term position (less than 60 day horizon at Schwab or a 120 day horizon at Fidelity to match their expiration times), we strongly recommend method #4. If you have a long-term position, we recommend using very liquid securities and approach #5 (unless you are an accomplished technical trader with option #3).
Keep in mind that stop-loss orders (which are market orders when executed) are not available for mutual funds, options, or individual bonds, but are available for stocks, ETFs, ETNs, CEFs, MLPs, and public royalty trusts. To deal with that problem, we have developed an in-house "stop alert" system that makes an end-of-day evaluation of securities it tracks and emails QVM, as well as the client if they wish, to suggest it is time to exit a position. That is the only practical solution we have for stop loss option #4 after the order expires.
Until Schwab or others implement a multiple conditions option for non-expiring, investors are left with choosing their form of protection from alternatives each with positive and negative attributes.
We hope this article helps brokers more seriously consider the needs of investors for multiple conditions, non-expiring stop loss orders; and helps investors think more comprehensively about the pluses and minuses of different stop loss order approaches.
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