Stop orders are one of the tools traders have to automate their transactions and limit their losses. While they are not used extensively – according to Marketwatch, such orders are used 0.2% of the time – soon they will no longer be an option for traders on the New York Stock Exchange (NYSE). The stock exchange will also eliminate good-till-canceled (GTC) orders, which are orders that stay open at a set price until the investor executes the trade or cancels it.
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The change becomes effective February 26, 2016, at which point all existing stop and GTC orders will be canceled. The NYSE is not the first to eliminate stop orders – the Nasdaq is doing the same thing – but investors should be aware of why stop orders and GTC orders are being removed.
According to a statement issued by the NYSE last week, “Many retail investors use stop orders as a potential method of protection but don’t fully understand the risk profile associated with the order type. We expect our elimination of stop orders will help raise awareness around the potential risks during volatile trading.” In other words, the NYSE feels that your average investor might enter a stop order to protect him- or herself but lose far more than expected when the market is moving quickly.
But, like many things, the issue is more complicated.
Understanding Stop Orders and Their Risks
There are two types of stop orders. Stop loss orders let you buy or sell a stock after it reaches a particular price. At that point, it converts to a market order. The actual execution of the price may vary depending on how quickly the market is moving. It will usually be close, but not always – and sometimes it won’t produce the desired effect. If the market is moving quickly, the stock could trade exponentially lower after the stop order is activated.
It works like this: Let’s say you bought a stock for a long position at $100 but were worried the price could tank, you could enter a stop loss order so that it would sell at $92. That way you would limit your loss to 8%. However, sometimes the market moves very quickly. During breaking news and flash crashes, the stock could gap down. The next available share price could be several points lower than your stop order whether that next share price is $88 or even less.
Now imagine that there is a flash crash and the stock immediately rebounds. Not only did you sell out before the recovery but you sold for less than you ever bargained.
Stop limit orders are like stop loss orders, but they only trigger when the stock reaches the exact stop-limit price. If the share price skips that number, the stop-limit order is not activated. For instance, you could buy a stock at $100 per share and enter a stop-limit order for $92 but if there is a flash crash or news alert and the next price is $91.99, you are left holding that position because your stop-limit order was not activated.
There are cases when a stop loss order is triggered by a sudden downward momentum, and then the stock spontaneously recovers (maybe even far enough for the position to be profitable), leaving the investor unhappy he or she sold.
When the flash crash happened on August 24, share prices started falling, and they triggered stop orders. All those positions were automatically sold, driving the prices lower, and lower. It was a pile-on effect that cost a lot of people a lot of money.
There are Always Brokers, What’s the Difference?
Now, even though the NYSE and Nasdaq exchanges are eliminating these orders, brokers can still offer a similar service through the brokerage – but that is automated trading and not a stop order on the floor. In fact, many investors will have access to tools that let them automate when they sell or buy, and such tools will have the same risks outlined above.
“The long-term solution is for retail investors not to put in stop orders and to pay more attention to what they have and when they might want to sell what they have (or buy more of what they have),” explains CNBC. “And that’s what the NYSE is trying to say.”
But there is another issue at play – transparency.
When an investor enters a stop order, it is transparent. Other investors can see it. Some investors (and investing algorithms) “run the stops”. This means that when a stock’s price goes low enough that it triggers a vast bulk of the stop orders investors have placed on the stock, such as when an established support or resistance level is reached, the person (or machine) running the stops buys in big. In response, the share price reverses direction and possibly even rallies. In contrast, when you arrange for an automated trade via your broker, it is not made public.
Playing it Safe
If you are a casual investor, not having access to stop orders is not necessarily a bad thing. In fact, it could save you a bundle. A safer option is to set a price alert. That way when one of the stocks you like hits a point at which you would like to buy or sell, you can get an email or text message and then take action.