Sunday, May 9, 2010

Do Not Use Stop-Loss Orders or Market Orders

I think a lot of what happened to the stock market on Thursday was simply due to stop-loss orders being filled. As they were filled, the market dropped more, causing even more to be filled, in a chain-reaction. With computerized trading, it all happened very quickly.

About 11 years ago, I learned the hard way not to use stop-loss orders when trading stocks.

A stop-loss order is a standing order from you to your broker to sell your holdings in a stock if the price of that stock goes down to a certain level. With a stop-loss, you don't have to be right at the computer or on the phone to protect your investment if it starts to crash.

Except that it doesn't really work that way.

I owned a significant amount of a thinly traded stock in 1999. The price had increased from $3 to around $5, and I was concerned that it would drop when I wasn't watching. So I put in a stop loss order at $4.50, just in case.

Within an hour, the stock price dropped to $4.50, my stock was sold, and then the price hopped back up to $5.00. Because it was thinly traded, and there were buy orders waiting to be filled, the market maker in the stock simply dropped the price to pick up my stop loss -- and everyone else's in that range too.

Since then, I have seen similar things happen quite a bit.

It is important to note that once the stop-loss price limit is breached, your stop-loss order becomes a market order. If the price is falling quickly, the order may execute at a price far below what the limit was. I think this happened a lot on Thursday, driving the whole stock market lower and lower.

Of course, you should never put in an order to sell "at market". The market price can be whatever the market makers want it to be. You never know at what price your trade will execute -- particularly in a volatile market.

There are now "stop-loss limit" orders that will trigger when the stop-loss price is breached, but will only execute at that price. But if the price is falling quickly, it may not execute at all.

So watch your investments closely, keep your stop-loss limits in your head, not as formal stop-loss orders, and never use a market order.


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