How stop-loss orders can create huge losses

IIROC wants small investors to understand the implications of recent changes in capital markets.

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In our Investor 500 issue, my esteemed colleague Tom Watson wrote about the rise of high-frequency trading. As long as stock markets have existed, not all trading has been conducted with a keen eye on financial ratios, management strategies and earnings announcements. But in recent years speculation has taken on a new flavour. Electronic high-frequency trading systems “generate huge profits by analyzing trading instructions issued by other investors, getting ahead of them in the order flow and then rapidly flipping massive numbers of stock for quick penny scores,” Watson reports. According to one trading specialist he spoke with, the average holding time for stocks on Wall Street has consequently shrunk to 22 seconds. This is not your grandfather’s stock market.

What does this mean for the small investor? To answer that question, the Investment Industry Regulatory Organization of Canada (IIROC) is holding an investor forum on May 30th. “What investors have to realize is that for the past few decades, they have been able to make certain assumptions about how their orders will function,” says Kevin McCoy, a senior policy analyst. “The risk today is that certain orders may in fact work as designed, but not as they were intended.”

A particular concern is stop-loss orders. They allow investors to set a floor price for a stock they hold. If it dips below that price, the broker is instructed to sell it post haste. Stop-loss orders have traditionally been regarded as a great way to contain risk. If you’re off vacationing in the Czech Republic, for instance, you probably don’t want to be checking your portfolio every day to see if one of your stocks has imploded.

Yet some investors discovered an unexpected problem during last year’s flash crash. Stocks unexpectedly plummeted on May 6, with some large international companies losing nearly 100% of their value. In such circumstances, if a broker is instructed to execute a stop-loss order at market price, the investor could suffer huge losses during an anomalous blip that corrects quickly. The solution: set limits on the executive price of stop loss orders. “With limits, investors might risk having their orders not being executed,” McCoy says, “but at least they won’t risk having those orders executed at an unanticipated price.”

IIROC’s forum will be held at 4:15 p.m. at The Design Exchange, located at 234 Bay Street in Toronto. Admission is free. Those unable to attend might be interested in a new web-based learning tool IIROC says it will launch at the forum, called “IIROC’s Guide to Trading on Equity Markets.”

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