The risks of market and stop-loss orders

By Active Trader Staff
One of the more surprising issues that emerged in the aftermath of the May 6 “flash crash” was a debate over whether market orders (including stop-loss orders) either exacerbated the sell-off or were at least evidence of a gaping hole in the education of the average investor.

In short, some industry participants voiced concerns that many panicking and investors and traders got crushed that day because they used market orders or standard stop-loss orders to get out of the market. Some even argued market orders exacerbated the sell-off.

Debate aside, there are some compelling arguments why traders and investors — especially less-experienced ones — are better off using limit orders, even in normal market conditions.

Order types and May 6
While a limit order (e.g., “buy 100 shares of AAPL at $197.50) allows you to set the price at which you will buy or sell, a market order (e.g., “buy 100 shares of AAPL at the market) is designed to be executed immediately at the best possible price — at the lowest available offer price or the highest available bid price, depending on whether the order is a buy or sell. In normal market conditions in a highly liquid market with a very tight “bid-ask” spread — i.e., a small differential between the lowest current sell (offer) price and highest buy (bid) price — a market order can get filled very near the most recent price quote. However, when a market is moving sharply higher or lower, it may get filled at a much worse price than what you hoped or expected.

A stop-loss order is designed to cap losses on an open trade and is placed below (for an open long trade) or above (for an open short trade) the current market price. For example, a trader who buys at 20 may place a stop-loss at 19.50 to cap the loss on the trade to .50. However, there is one drawback to a stop-loss: As soon as the market trades at the stop price and the order is “activated,” the order becomes a market order, and there is no guarantee the position will be exited at 19.50. Again, in volatile market conditions, price could quickly drop below 19.50 and the order might get filled at a much lower price.

On May 6 the market was volatile by any definition. At the worst point in the sell-off the S&P 500 index tumbled more than 6 percent in 25 minutes. The market dropped so fast it quite understandable that some investors, desperate to get out of the market and repeatedly unable to get filled using limit orders, resorted to market orders. Other investors who had placed stop-loss orders to limit their exposure found these orders offered no protection: For a while, bids simply evaporated and many stocks traded down as much as 60 percent before the market rebounded (many of these trades were cancelled after the fact, however). To make matters worse, the market rebounded more than 6 percent over the next 25 minutes (Figure 1).



A trader could have conceivably entered a sell stop-loss order to prevent an existing long trade from becoming a loser right before the 6-percent sell-off and then watched as the trade got filled near the low of the day — and then suffered the added indignity of seeing the market rally back above where it had been before the stop was placed.

Standard stop-loss orders or market orders might be perfectly appropriate in very liquid markets and in non-volatile conditions. However, it takes experience to know what those markets and conditions are; there is little reason for most traders — and especially newer ones — to expose themselves to unnecessary risk by trading without a limit.

For the complete article, see the September 2010 issue of Active Trader magazine. Click here to subscribe.



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