Stop Order Drawbacks
By Roger Nusbaum, AdvisorShares ETF Strategist
The Wall Street Journal had a quick write up to address the odd trading that occurred with some ETFs on Monday as the Dow traded lower by 1100 points for a few minutes (the S&P 500 was lower by about 94 points). Included in the article was a mention of advisors with stop orders who got stopped out on client positions in ETFs when apparently quite a few ETFs traded away from their indicative value for a time in the heat of the severe decline and almost equally severe snapback. ETF.com reported that there were a handful of ETFs that traded 40% away from their indicative values and a couple of the funds were not tiny. Anyone stopped out in that fashion arguably has a permanent impairment to their capital if the exchange or the brokerage doesn’t make them whole.
Quite a while back there was a popular strategy with stop orders that involved putting a stop order 8% away from the market under every stock in the portfolio. This never made sense to me as an 8% move on a blue chip soda company is a much different kind of move than 8% for a Chinese solar company. One of the advisors mention in the article disclosed having the same 15% stops under all the ETFs he owns for clients and “almost every ETF he had was sold.” The article did not say whether he was stopped out on both equity and fixed income funds or just equity but 15% under equity funds and 15% under fixed income (if that is indeed the case) isn’t much different than the soda company/Chinese solar example.
Earlier in the week I was joking with a colleague about how in the 1990’s the online brokerages had outages or other forms of disruption all the time, it was after all the dawn of the internet as a household utility, but that the exchanges never had problems. Somewhere along the way that reversed, brokerage downtimes have all but disappeared while at the same time between the flash crash of 2010 and a couple of failed IPOs (as in failed execution) the exchanges regularly send someone on stock market television to reassure participants that things are working.
I used to use stop orders a little but phased them out. The last usage of one I can find is 2006 while I may have used one subsequently I had stopped by the time the flash crash occurred. The idea of erroneous prints has always existed but these wide scale mis-pricings not due to something at the brokerages seems to be on the increase and as you will see in the article, the brokerages tend not to protect the customer in a way that most people might expect.
With that backdrop and how recent the flash crash happened it is baffling why someone would use stop orders in an across the board fashion as described in the Journal piece.
A new wrinkle to why this is a bad idea (new to the discussion on this site) is that in the face of 10 minute, 1000 point move should the typical investor be placing any trades at all? In some instances the answer is yes but a large, tactical shift to a defensive posture in the face of what was almost a carbon copy of the flash crash seems like a terrible and unnecessary outcome.
I am reminded of the quote “don’t just do something, stand there” which is a play on words of course and a quote I’ve seen Rob Arnott and Jack Bogle use (for any Cliff Clavens out there, it is actually attributable to someone named Martin Gale). Part of actively managing a portfolio is know when it is better to take no action. That can be difficult but still the right thing at times. Yes you might be able to move quick enough to fade some overly done 20 minute move but far more important is not trading in the same direction as some overly done 20 minute move. If you believe there is no way to know something is overly done that would be all the more reason to avoid stops.