By Mary Pilon, Karen Blumenthal and Jason Zweig | May 15, 2010 12:01 a.m. ET
Image credit: Rich Anderson, “Mixed Messages” (2009), Flickr Creative Commons
Last Thursday’s “flash crash” gave investors a crash course in the perils of stop-loss orders.
A stop-loss order is designed to protect investors by triggering a sale once a stock reaches a certain target. The trades are computer-activated and are based on criteria set up by the investor in advance. Many of them were triggered on May 6 as hundreds of stocks briefly plunged by 20% or more.
The problem? Because prices were falling so rapidly, the stop-loss trades couldn’t be made quickly enough, and many people’s shares were sold at prices far below their trigger price. Most of the stocks then rebounded quickly, making the episode all the more painful for the people who had been bounced out at the bottom.
That is precisely what happened to Gary Pinder, a management consultant who lives in eastern Maryland.
In March 2009, Mr. Pinder sold his position in the Vanguard Total Stock Market Index mutual fund and moved the proceeds into the Vanguard Total Stock Market ETF, or VTI, an exchange-traded fund that holds an identical portfolio. He says he switched to VTI “purely to take advantage of the automatic stop-loss capability” offered by ETFs but not by mutual funds. “You can’t time the markets,” says Mr. Pinder, who has an M.B.A. from the University of Chicago. He adds that he wanted “to take the emotion out of selling.”
Mr. Pinder decided to set a stop loss of 20% below the latest high price of his ETF shares. He updated the stop-loss point whenever the market made a major upward move. On May 5, Mr. Pinder logged on to his account with Charles Schwab and raised his stop-loss on VTI from “the $46 range” to $49.17.
The next day, Thursday, was the flash crash. At exactly 2:48 p.m. EDT, according to Mr. Pinder, his shares fell through the floor. But Mr. Pinder wasn’t “stopped out” at $49.17. Instead, with the market in free fall, his instructions automatically converted to a market order that sold his shares at prices far below his trigger price—at an average of $41.15.
“Within minutes,” says Mr. Pinder, he “had lost all my gains from remaining steadfast in the market throughout the previous 18 months.” His net worth, Mr. Pinder estimates, declined by 10% solely as a result of the failed stop-loss.
To top it all off, as the market rebounded from the flash crash, VTI quickly roared back to close the day at $57.71.
When Mr. Pinder came home that evening and logged onto his account, “I was kicking myself,” he says. “Had I been overthinking my investing strategy? Had I overprotected myself for no reason?”
As Mr. Pinder’s case shows, stop-loss orders can be much more dangerous than their name would imply.
Even the term “stop-loss order” is widely misunderstood. That is because, technically, once a stock’s price reaches the target, the stop-loss converts to a market order, meaning the trade is automatically executed at the market price.
For example, an investor who owns a stock trading at $50 could set up a stop-loss order at $40. But if the stock is falling quickly it could blow right through $40; it might next change hands for $30, $20 or even one penny, and that is where the trade would be executed.
Stop-loss orders can also have inadvertent tax consequences if you have a gain. The capital-gains rate is 15% on investments held for longer than a year but up to 35% on those held less than a year. So a stop-loss order triggered in, say, the 11th month of your ownership could result in a serious tax burn, says Lyle Benson, a CPA with L.K. Benson & Co. in Baltimore.
In addition, people who were sold out via a stop-loss trade during the flash crash and who buy back the same or “substantially identical” securities before June 7 will be subject to wash-sale rules, says Robert Willens, a New York tax expert. That would mean they can’t deduct any capital loss sustained on the original sale.
It’s difficult to pin down how widely stop-loss orders are used and who uses them. Federal regulations generally prohibit brokers from placing stop-loss orders without first securing their clients’ permission. The Securities and Exchange Commission is looking at the use and impact of stop-loss orders as part of its review of what caused the flash crash.
“We believe it is critical to understand the causes and effects of this event,” SEC Chairman Mary Schapiro said Tuesday in her prepared remarks before a congressional hearing, “so that we can work to ensure that it does not occur again.”
Matt Billings, director of trading services for online brokerage Scottrade, suggests that investors add a “limit” to their stop-loss order, thus ensuring that a stock won’t be automatically sold at an artificially low price. Mr. Billings says that fewer than 10% of Scottrade’s customers use stop-loss orders, but more than half use limit orders, specifying the exact price at which they want to buy or sell shares.
With a stop-limit order, traders typically enter two prices—a stop price and a limit price, or the lowest price at which the stock can be sold. People with stop-limit orders fared significantly better last week than those with regular stop-loss orders. (But a stop-limit order has risks, too: If a stock plunges and never comes back, a la Bear Stearns, the stock might not be sold at all.)
Another possible solution for investors trying to keep an eye on pieces of their portfolios: set up an alert without a trade attached, says John Gabriel, an exchange-traded fund strategist at Morningstar Inc. “I’m a fan of actively monitoring your portfolio,” Mr. Gabriel says. “You want to find out why it’s moving.”
Despite the many negatives, Ron Howard, a retiree who lives in Boca Raton, Fla., likes stop-loss orders. He argues that stop-losses can protect profits, but recommends them only for sophisticated investors. “No matter how diligent you are as an investor, no matter how much homework you’ve done on what companies you have, the gods can still ordain that you can get hit,” he says.
Mr. Howard says stop-loss orders helped him avoid losses in oil stocks in the past but he is “very judicious” about entering them. He wasn’t hit last Thursday by stop-loss orders.
As for Mr. Pinder, he thinks of his stop-loss experience—which vaporized a 10th of his net worth—as “possibly another year added to our working lives.” He explains: “When I first started working, I hoped to have the option to retire by age 50. The bursting of the dot-com bubble probably put us back to 55. The 2008-2009 crash put us back to age 60 or so. And now we’ll maybe have to work an extra year, or just live with less money whenever we do retire.”
Still, he is philosophical about how his stop-loss turned into a big loss: “It’s disappointing and annoying, but there are much worse things that can happen in life than this.” Concludes Mr. Pinder: “I’m not sure setting a stop-loss would be a good decision to make again. Markets are markets, and we can’t really control them.”
—Jane J. Kim contributed to this article.
￼Source: The Wall Street Journal