The Pitfalls of Stop Loss Orders

Investopedia defines “Stop-Loss” orders as the following:

 An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit an investor’s loss on a position in a security. Investopedia explains “stop-loss” orders.

Most individual investors have been conditioned over their investing lifespan to believe that stop orders (also commonly known as “stop-loss” orders) are a must when entering a position. While this used to be the case, it is no longer true. With the rise of algorithmic and high frequency trading over the last 8+ years, stop orders have come to cause more harm to the average investor than good. This is because the stop order acts as a magnet for computer programs. The programs can see your (stop) order in the system, and will literally go “hunt” it. This sometimes causes an investor to get stopped out of a position unnecessarily. Here is a good example courtesy of Bloomberg:

Stop orders work like this: A customer requests that 1,000 shares of Company X get sold once the price falls to $20. But $20 isn’t guaranteed. If the stock plunges from $30 to $10, without hitting any intermediate prices first, the stop order might get executed at $10. According to BlackRock, that’s a surprise to some small investors. NYSE eliminates stop-loss order type.

The New York Stock Exchange apparently agrees: it has recently announced that they are eliminating the “stop” orders effective February 26th, 2016.

So while the idea of a stop-loss order is a good one, sometimes it can actually harm you. Now that stop-loss orders have effectively been banned, when you open a position you should still keep a mental price level in your head that will cause you to exit the position.