Not Rich Yet | Managing higher incomes

May/10

7

Why people with stop-loss orders got creamed yesterday

Yesterday the market took a major nose-dive – whether computer glitch, gremlins or human error was the cause isn’t quite clear yet.

Some of the trades that happened during that very scary nosedive were canceled after the fact. However, the vast majority were not. So if you owned shares in P&G and had a stop-loss order, you may have lost up to 37% of your investment.

What is a stop-loss order?

A classic stop-loss is a kind of insurance you can use with your stock investments. You can set a “panic” threshold so if the price of your stock drops below the threshold, your holding in that stock are sold at, theoretically preventing you from incurring even greater losses.  E.g. if you own Goldman Sachs shares, that trade for $150, you could set a stop-loss at $130. If the price drops beneath $130, your shares are sold. Traders often use stop-loss orders as a kind of insurance against a stock tanking in a big way while you are not paying attention.

However, a stop-loss order can also ruin your day.

It is important to understand how a stop-loss order works. A stop-loss order is a dormant order that is converted into a market order when a price threshold is met. This does NOT mean you are guaranteed that the stock will sell for your stop loss price. Instead, it well sell at the next best price. That may be your stop-loss price or a couple cents below it. It may however sell for far less than your stop-loss price. In the case of P&G, Apple, Sam Adams and a bunch of other stocks yesterday, the best next price may have been far below your stop-loss price. Sam Adams for example went from $56 to $0.01 in a heart-beat. If you were unlucky your converted stop-loss may have sold at the very trough of that decline. In the case of Sam Adams, the SEC decided to undo the trades, but for P&G and others, people weren’t as lucky.

What does this mean to me?

Stop-loss orders tend to do fine with high-volume stocks – there are enough trades happening so that prices evolve more smoothly, and that your sell price will be close enough to your stop-loss price. However in low-volume stocks prices tend to move in jerks they only move when bid and ask prices meet, so the risk that your sell price will be far below your stop-loss price is much higher.

So know that using stop-loss with random small stocks is risky.

Next, you could use a stop-limit order. This means that your stock sell order is triggered when a threshold is met – same as a stop-loss order – except you choose a limit price. This means that the stock is sold for a minimum price, typically your stop-price. This means the stock only sells if price is above the limit. If the price is in free fall, no-one will offer a price greater than the stop price that the price just rocketed past, and you end up not selling your shares – no-one offered you a price that met your limit.

So both stop-loss and stop-limit orders are helpful insurance policies, esp. for large stocks, but they are not fool proof and can end up hurting you bad if the market or your stock tanks.

Buyer beware!

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