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.

Flash Crash

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.

11 Responses to The Potential Dangers of Stop Loss Orders

  1. Great points Adam! I think stop losses can be a great tool to use, as long as you do so wisely. I’ve seen too many set them and just forget it. Then they get upset because they were sold out, which is really only their fault if they did not watch it. What happened yesterday was crazy and I think we’ll only see more of it. We can’t always count on Nasdaq to come in and bust the erroneous trades like they did after the Flash Crash.

    • Thanks John and you’re absolutely right, it’s very difficult to have the best of both worlds. If you’re going to invest on a semi-short term basis, you have to check in regularly to make sure your stops losses are still at a level you’re happy with.

  2. Thanks for sharing this mate. I had no idea about how the stop loss order worked but I had heard of it. I don’t do my own investing but I’m learning bits and pieces here and there. I can understand exactly what the concern would be with the stop loss and the algorithmic trading and I’m not sure if I’d trust my money to these glitches then again who has all day to stare at their computer.I’d have to look at the investments as long term to offset the ups and downs. Risk seems like it’s everywhere when it comes to investing. What would you do?

    • No problem Mr.CBB, if you’re looking to invest on long term basis then I’d do plenty of research, stick to historical blue chip companies and then have confidence in your position. Stop losses do have their place but in my mind only to prevent a disaster. Investing will always be a risky business but if you go for solid long term companies and the figures stack up, your need to rely on stop losses should be reduced.

  3. Really it’s just another danger in active trading. There is a reason much of the literature suggests that index investing with periodic rebalancing outperforms most active trading…

    Good article!

  4. Ben says:

    Good points all around. With high frequency traders controlling most of the market volume on a daily basis it can make for a crazy ride. They provide the volume until you really need it and at that point their algorithms have them on the sidelines. This will continue to be an issue until the regulators do something (maybe make transactions in different increments than pennies). Interesting topic, the graph of the market on that day is wild.

  5. Jose says:

    Nice article! As you know, I’m a huge fan of the stop loss order. I tend to use trailing stops though, I’m always game for a few extra points :). I will usually set a trailing stop when I’m ready to get out of a position, although during market runs (like we’re in now) I’ll put stops underneath positions that have pretty hefty gains to protect the gains. There is definitely a risk, especially when and if there’s a sudden and dramatic drop in a stock price, you can find yourself having sold a stock for way below what you were willing to take! All in all though stops are an important part of my trading strategy so I’ll accept the risk.
    BTW, I like the new look!

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