The “Flash-Crash” and Stop-Loss Orders

We occasionally get questions from clients regarding stop-loss orders and why we do not use them on some or all of the positions in client accounts. I believe there is much misunderstanding about these types of orders and how they work. I will briefly try to highlight how this type of order works, and use the recent “flash-crash” as an example of its potential pitfalls.

On May 6, the Dow Jones Industrial Average lost 565 points in 7 minutes between 2:40pm and 2:47pm, and then gained 590 points in the next 10 minutes. Some stocks, such as Accenture (which opened that day at $41.94 and closed at $41.09), traded for pennies for a few seconds. Long-term investors who do not concern themselves with intraday price movements probably would not have even noticed this strange fluctuation. When we buy a stock, we intend to hold it for at least 4-5 years and possibly even longer. From our perspective, while this type of intraday fluctuation was puzzling, it did not reflect anything adverse about that particular company or its earnings prospects.

A stop-loss order is a sell order entered at some price below the current market. When the stop price is hit, the order becomes a market order. It is then automatically submitted and filled at the current bid price for that security. Let’s take an example: Say Accenture is trading at $40 and you decide you are willing to lose no more than 20% of this value, so you enter a $32 stop-loss order. If the stock trades at $32 or below on any particular day, your stop is triggered. The order is sent to the NYSE where it is filled at the current bid price. In most cases, this is reasonably close to the stop price unless it is a fast-moving market that day. But what happens in a fast market?

On the day of the flash-crash there were not enough bids on the NYSE for many securities, therefore these orders were routed to other electronic exchanges that do not have the same circuit breakers. By the time your $32 stop was routed and filled (within seconds), you could have ended up with a fill price of $1 or less. The exchanges later cancelled trades that were 60% or more away from the 2:40pm price, but that would not help you if you got filled at $20 for your Accenture shares (you would have been down about 50%, so the trade would have been honored). Then the stock ends up closing at $41.09 an hour or so later, so the stop-loss order did nothing to protect you from downside risk and got you out at an abnormally low price. The crucial thing to remember about a stop-loss order is that it is not a guarantee to get you out at a specific price!

The exact causes of the flash-crash are still being investigated and may never be completely revealed. New regulations are being proposed by the SEC to slow down or stop trading in individual stocks with large price movements during most of the trading day. Whether these regulations will be successful in reducing intraday volatility is uncertain. We remain focused on earnings and dividend growth as the drivers of stock prices over longer time periods, rather than short-term price movements.

Bill Hansen, CFA
June 18, 2010

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