Temporary market “failures” like the one we witnessed on August 24, 2015, or the Flash Crash on May 6, 2010, heralded in a flurry of personal finance articles instructing investors to use stop orders to protect themselves from spikes in market volatility.
Here’s how the stop order works: You buy a stock at $50, and enter a stop loss order to sell at $47.50, which limits your loss to 5%. When the stock falls to $47.50, it is sold automatically, thereby protecting you from the stock tumbling lower. That trading strategy works just fine if you knew the stock would continue to fall and you knew when to buy it back. But what about markets like those we’ve experienced recently where stocks fall only to rebound seconds later? In fact, both crashes noted above came and went in less than an hour. It is very likely that investors using stop orders experienced seller’s remorse especially if the stop order resulted in a loss larger than 5%?
Another problem with a stop loss order is that it is transparent to the rest of the market. And some market-makers are fond of playing a game called “run the stops.” They buy the stocks being sold, betting the stock quickly reverses direction and rallies.
In an attempt to deal with the ramifications of huge intraday swings, the New York Stock Exchange recently announced it would no longer accept stop orders as of February 26, 2016. The Nasdaq has also barred them.
In a press release, the NYSE first cited the issue that a stop order could be triggered after a big downward move, but that the stock could quickly recover its value. Another risk mentioned is that in a quickly falling market, it’s possible the stock could be sold at a much lower price than the price the stop order intended the sale to be executed at.
Above all, with stop orders you surrender control of your portfolio to trading algorithms. However, a computer cannot assess the causes of a particular market nose dive or how long it might last.
I have never been a fan of stop orders for the simple fact they will only work if you know that the market is going to continue to decline and you know when to get back into the market. I have always believed that if an investor is concerned about risk the first decision to be made should be the asset allocation and then they should be fully invested 100% of the time.
Decisions to buy and sell or when to rebalance should be made by you and your trusted – human – advisor based upon your agreed upon asset allocation and investment plan.