Stop-Loss Orders: A False Sense of Security

The dust is still settling and fingers are still being pointed in the aftermath of what is now being called the "flash crash." Sorting out the mess will require much time and likely result in more fingers being pointed in multiple directions, but we simply have to accept the fact that markets will occasionally suffer bouts of extreme volatility--and be properly prepared to ride those waves until calmer waters prevail.

While at this point there seems to be more questions than answers, we can't help but feel for some of the unsuspecting victims of this erroneous market action. But the first step in avoiding disasterous results in the short term is to avoid taking potentially perilous actions. Followers of Morningstar's exchange-traded fund research are more than likely familiar with our strong preference toward using limit orders when executing ETF trades. This helps ensure that you get a price at or extremely close to the fund's net asset value. After all, in a properly functioning market, a fund is worth simply as much as its constituent parts. If you are selling and not getting something very close to fair value, we would recommend not selling at all.

One type of trade that we vehemently avoid more than any other is known as a "stop-loss" order. Consider yourself warned: If you perform an online search for this term, you're likely to find some misleading definitions. For instance, you may come across an explanation like, "setting a stop-loss order for 10% below the price you paid for the security will limit your loss to 10%." Our main problems with this statement are that it is blatantly false, imparts a false sense of security, and can lead to truly disastrous results.

Such misinformation likely makes employing a stop-loss strategy sound appealing to a risk-averse investor who cannot actively monitor his portfolio. In the case of a traditional stop-loss order, once the "stop" price is reached, a market order to sell the security is entered. Hence, the trade will be made but not necessarily at or near the predetermined stop price. As was the case last Thursday, if there is insufficient liquidity or the market is moving quickly, there's a good chance that the order could fill at unfavorable prices.

In order for a fund to trade near net asset value, the prices of all of the individual securities in a fund must be known. A mutual fund accomplishes this by waiting to the end of the day. This periodic pricing masks the intraday volatility. There is little risk for the mutual fund company because all of the prices at the end of the day are known. But for an ETF, which trades throughout the day, waiting until the end of the day to set a price is not possible. Instead, the ETF depends on arbitrage. In order to keep the price trading near net asset value, a trader needs to be able to quickly calculate the net asset value. The magnitude and urgency of the calculations lends itself to electronic and algorithmic trading.

When volatility increases, so does the uncertainly of the net asset value. In response, a market maker is going to widen out his bid-ask spreads and reduce trading until after making an assessment of market activity. The market makers and algorithmic traders are using sophisticated order instructions. They are not going to make market orders when they have no idea where the market is. As an individual investor, we need to be aware of when our trades are going to be executed and at what price. After all, a stop-loss order is a very unsophisticated form of algorithmic trading. It becomes a market order precisely when volatility has increased.

To paraphrase Peter Lynch, if you buy a stock with a stop-loss of 10%, the only thing you are guaranteeing is that you'll lose 10% on that trade. We couldn't agree more. In fact, we often quip that a more appropriate name for stop-loss order would be guaranteed loss order. Those of us who experienced the violent volatility that was so prevalent at the height of the credit crisis should also agree with Lynch's point of view on the matter.

Of course, there are likely many investors/traders who swear by the use of stop-loss orders. A popular strategy we've started to hear more of as people dip their toes back into the market is the use of trailing stop orders. Such dynamic orders are used with the intention of maximizing profit when a security's price is rising and limiting losses when it falls. For example, a $1 trailing stop on a $20 security would be triggered if the price fell to $19 or below. However, if that security were to rise to, say, $25 (without breaching the $1 trailing stop) then the stop price would reset to $24, thereby helping the investor "lock-in profits."