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The Hidden Dangers of Stop-Loss Orders

Risk management is one of the most important considerations of successful traders. They understand that risk will never be eliminated, so they take steps to minimize their losses when they are on the losing side of the market.

Rules for risk management can be fairly simple, but they need to be determined by the market.

Some traders enter stops based on their entry price, maybe 10% or 20% below the price they paid. They enter stop-loss orders at that level and leave them there, confident that they will suffer only limited losses. This can lead to automatic selling in a crash and permanent losses. Market action during the May 6, 2010 Flash Crash demonstrates the problem with this approach.

SPDR S&P 500 (NYSE: SPY) and iShares Core S&P 500 ETF (NYSE: IVV) both track the same index -- the S&P 500 -- and generally trade very close to each other, at least when trading gains and losses are considered on a percentage basis.

That relationship broke down in the Flash Crash as standing stop-loss orders seemed to cost investors in IVV thousands of dollars.

The chart below shows that IVV fell more than 22% in less than 90 minutes that day before recovering quickly. SPY fell only 8.5% over that time. Both quickly rebounded and traders who sold later that day or the next day suffered much smaller losses.

We cannot know precisely what happened on that day, but it looks like stop-loss orders caused the rapid price divergence between the two ETFs. IVV is less widely traded than SPY, and a few orders could have a large impact. A stop-loss at $90 when there is no liquidity in the market could be filled at $88.87, and isolated orders between $104 and $90 could have caused the big decline.

IVV opened on May 6, 2010, at $116.64, and SPY started the day at $116.26. Because of the difference in fees and trading costs, some difference between the two prices is normal. Because IVV has lower trading volume, stop orders were triggered quickly. At the bottom, an owner of IVV lost more than $16 a share because they had an order set up for what they thought was protection.

This is the most graphic illustration of the danger of standing stop-loss orders I have ever seen, but crashing markets tend to feed on stop-losses. Reversals are common after big declines, and can be a better time for traders to get out. In the case of the Flash Crash, traders could have gotten much better prices for sells entered at the market price later that day or the next day.

The location of stops is also important to consider. Some traders rely on rules and enter stops 8% or 20% below their buy price. Although the trader hopes their order is never executed, the market views it as an order someone wants filled.  These orders sit in the market, and market makers or high-frequency trading firms see them as valid orders that they should execute if possible. In that way, they can act as a magnet for the price action.

Instead of using a standing stop-loss order to manage risk, traders should consider the alternatives:

1) Use mental stops instead. Rather than setting a stop-loss order, traders could wait for prices to reach their "stop level" and then enter a market order only after prices fall below their desired sell price. As I mentioned earlier, reversals are common after big declines, and can provide a much better opportunity for traders looking to sell.

2) Manage risk with money management. Maybe you don't want to lose more than 2% of your account value on any trade. You could then buy an amount worth 2% of your account value and not worry about a stop. Instead of relying on a stop-loss order, you would need to determine other exit rules based on market action to indicate when to get out of the trade. This would probably increase your total returns in the long run.

For small accounts, the 2% risk level is too small. With stocks, 10% or even more for small accounts would be an appropriate amount of risk to allow for long-term trends to unfold on winning trades.

Assess your exit strategy and develop a system based on market action for closing trades rather than risking a percentage of the entry price as many individual traders do.