The Potential Dangers of Stop Loss Orders
Unless you have the time to stare at a computer screen all day long and keep an eye on your investments, protecting yourself from quick market falls can be tough. To get around this problem many casual traders set up stop loss orders on their trading positions so that shares automatically get sold if the share price drops below a certain level. Last night though I read an interesting news article on Bloomberg that highlights a big potential danger involving stop losses, a danger that could lead you to exit a trading position quite unnecessarily if the computer is allowed to take over.
Trading has changed
I wrote an article not so long ago about a relatively new form of trading known as Copy trading, an offshoot of social trading which allows you to automatically copy the trades of some of the worlds most successful Forex investors. Another form of computerised automatic trading I learned about last night whilst reading the Bloomberg article is algorithmic trading. Algorithmic trading allows trades to be made automatically based upon what a computer reads from news articles posted around the web or even on social networks. Although the idea of algorithmic trading sounds good in theory, it has the potential to cause big problems for you and your stop loss orders.
If you’re an active trader you might have noticed that the S&P 500 and the Dow Jones fell significantly for about 5 minutes yesterday, the Dow actually fell around 145 points. What caused such a short term and sharp drop? Apparently it was all down to a tweet! Hackers managed to get into the Associated press Twitter account and sent out a fake tweet stating that explosions had been reported at the White House and that President Obama had been injured. If you’re a human trader you would likely take this report with a pinch of salt and check your preferred news site to verify the report. Unfortunately automatic algorithmic computer trading lacks this kind of human intelligence, the algorithms took the tweet as fact and started selling off shares.
But I don’t Use Algorithmic Trading, I’m safe!
Unfortunately this is not the case. As these computer controlled platforms started selling off shares, the stop loss orders set in place by many rightly cautious investors were triggered, leading to increased selling which further exacerbated the problem. Imagine the horror as many traders logged into their online trading accounts only to see that they’d sold out of a good trade all because of a 5 minute computer generated glitch.
I suspect that even after yesterday’s glitch, many people will still use stop losses on their trades to protect themselves from large sudden drops. Yesterday’s fiasco really does highlight though the potential dangers of setting stop losses on your positions in a world where computers seem to be making more decisions than ever before.
Think Carefully about your Stop Loss Level
If you are going to continue to use stop loss orders as part of your trading strategy, yesterday’s drop shows how important it is to think carefully about the level you set them at. If you set a stop loss too high you’ll be susceptible to any number of unconfirmed reports or freak trades, too low and you could lose out heavily if a rumour like the one reported in yesterday’s fake tweet turns out to be legitimate.
The glitch also shows the importance of taking a long term investment approach, especially if you don’t have the time to actively manage your portfolio all day long. If you choose to invest in companies that you think will perform well over the long term, then your need for stop losses will be minimized and you’ll be less affected by freak events like the one we saw yesterday.