The Dangers of Stop Loss Orders


Unbelievable day last Thursday.  The Wall Street Journal published an article on some of the wild  activity on the stock market (see link): 

http://online.wsj.com/article/SB10001424052748704292004575230634251738768.html

Some stocks dropped from normal prices of $50 or more per share down to near-zero or actually zero.   In other cases, some stocks surged.  Sotheby’s stock price actually rose from $34 to $100,000!  The quip of the day was from Diana Phillips, Sotheby’s spokeswoman, who said “Clearly, it has been undervalued!” in an email. 

While the exact causes are still under investigation, it was found that the automated rapid trading firms stepped to the sidelines when trading at the NYSE got clogged.  Trades that normally were executed in less than a second were taking a minute or more to execute, causing the firms to step aside since the market was not acting in a way conducive to their trading strategies.  When this happened, the liquidity dried up, such that there were sell orders but no buy orders, causing the wild price swings that were seen.

One issue that occurred was that stop market orders (see post “Types of orders” for a definition of a stop market order, https://smallivy.wordpress.com/2010/03/25/types-of-orders/) were executed because the price of various stocks fell below the limits that were set, causing investors to sell their shares at very low prices.  When the stocks returned to their previous prices, these investors were left on the sidelines with big losses.

This is an extreme case,  but in general I don’t recommend using stop-loss orders because various traders will move the prices of stocks around to try to hit these limits and cause the stock to move up or down.  If you buy quality stocks that you plan to hold for long periods of time, you’ll want to hold through the minor market fluctuations anyway.  If you have a big profit and are just using a stop order to avoid having to pull the trigger and risk missing out on future gains, you are likely to see the stock move down to your stop limit, sell your shares, and then continue on its merry way upwards.  Just sell the stock.   Remember the rule, “Don’t Get Cute”. 

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Clip art from http://www.retrographix.com/

One comment

  1. Hello, great post about stop market orders. I did use them from time-time, to make sure I keep myself from incurring a 10% loss. However, due to the market fluctuations, you make a great point.

    Feel free to check out my blog and comment too.
    http://chinameninvesting.wordpress.com I am trying to reach out to the investing community and share ideas.

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