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Investment Strategy

Stop the Madness: The Dark Side of Stop-Loss Orders

By Elliott H. Gue, on Aug. 31, 2015

At roughly 9:34 a.m. on Monday, Aug. 24, 2015, the Dow Jones Industrial Average had tumbled 1,089.42 points from its close the prior Friday. This painful collapse ultimately proved to be the index’s low for the week; the benchmark finished the week fractionally higher from its close on Friday, Aug. 21. The S&P 500 also gained 1.93% last week, despite Monday’s sell-offs.

However, some investors’ ill-advised risk-management strategies inflicted far more lasting pain on their portfolios, saddling them with losses that could take some time to recoup.

A Topsy-Turvy World

General Electric (NYSE: GE) boasts a market capitalization of $250 billion and generates about $130 billion in annual sales. On average, more than 40 million shares of the company’s stock trade each day. And millions of Americans have exposure to General Electric’s shares in their retirement accounts.

General Electric’s pedigree as the bluest of blue chips goes without question. However, this liquidity didn’t protect the stock from some whiplash-inducing moves during the most recent flash crash.

The common shares finished Aug. 21’s trading session at $24.59, opened Aug. 24 at $22.54 and plunged to a low of $19.37 in the first 5 minutes of trading. More than 1.4 million shares of General Electric changed hands at prices less than $20.50 per share in the first 3 minutes of last Monday’s trading session.

General Electric didn’t announce any major news to catalyze this downside. The company reported second-quarter results on July 17, topping the consensus estimate for revenue and delivering earnings that were roughly in line with analysts’ consensus estimate.

If you weren’t watching the tape on Monday morning or you happened to step away from your desk to pour a cup of coffee, you might have missed the plunge in General Electric’s stock.

By the time the market closed, the shares had recovered most of the ground given up over those frantic five minutes of trading and finished the session down less than 3%.

Fast-forward to last Friday, when General Electric’s stock finished the week with a 2.32% gain, outpacing the S&P 500.

Investors usually associate this sort of intraday volatility with penny stocks that trade over the counter, not General Electric.

And General Electric wasn’t the only bastion of American enterprise to endure a rollercoaster ride on Monday morning.

(Click table to enlarge.)

Pullback table Elliott Gue

Readers probably own at least a few of the blue-chip names on this list. Over the past five years, Roger Conrad and I have recommended Home Depot (NYSE: HD), CVS Health Corp (NYSE: CVS), JPMorgan Chase & Co (NYSE: JPM), Verizon Communications (NYSE: VZ) and Ford Motor Company (NYSE: F) in various investment newsletters.

Although blue chips like these form the bedrock of many investors’ portfolios, these five stocks rallied an average 21.9 percent from their intraday lows on Aug. 24 to their closing prices later that day.

All told, 29 companies in the S&P 500 gained more than 15% from their lows on Aug. 24 to where they finished the day.

If you held all these stocks through the panic, the 5 minutes of carnage barely registered as a blip on your brokerage statement. By Friday, Aug. 28, these 29 blue chips gained an average of about 0.5 percent from the prior week and 25.9% from the intraday lows hit on Aug. 24.

But Monday’s shakeout proved disastrous for those trading on margin and those who set stop-loss orders with their brokers as a risk-management tool.

Life at the Margin

Investors who buy stocks on margin borrow money from their brokers to finance a position in a stock. For example, if you wanted to buy 100 shares of a stock trading at $100 per share, your cost would be $10,000. With a margin account, you could post $5,000 and borrow the remaining $5,000 from your broker, using the shares you own in your account as collateral.

Buying stocks on margin magnifies your gains when a position moves in your favor. If the $100 stock in our previous example were to rally to $125, you’d have a $2,500 profit on your 100-share position—a 50% profit on your initial $5,000. Though illustrative, this example isn’t entirely accurate: In most cases, regulations prohibit individual investors from borrowing more than 50 percent of the cash needed to buy a position on margin.

However, margin cuts both ways. If a stock you’ve purchased on margin drops too far, the shares becomes insufficient collateral to guarantee the margin loan. Your broker would issue a margin call requiring you to either post additional cash to pay back a portion of your margin debt or liquidate part of your position to raise cash.

How does this work? Imagine that the $100 stock you purchased drops to $80 per share, a loss of $2,000 on your 100-share position. You’d have a margin loan of $5,000 and $3,000 in cash; your broker might ask you to sell some of the shares or to deposit cash to cover a portion of your margin debt.

The sharp selloff suffered by US equities on the morning of Monday, Aug. 24 resulted in a wave of margin calls and prompted some brokers to begin liquidating individual and institutional investors’ positions to reduce risk. These forced sales added fuel to the flames.

And when brokers liquidate your positions to satisfy a margin call, they’re looking to raise cash as quickly as possible, not to manage you out of the trade at a favorable price. In a thinly traded market, these forced sales occurred at terrible price points.

Stop the Madness

Most traders who buy stocks on margin have some understanding of the risks that such a strategy entails.

In contrast, individual investors who set stop-loss orders with their brokers probably thought this strategy would reduce their risk and limit their downside in the event of a blow-up in a particular stock. In some markets, stop-loss orders—especially those set indiscriminately—can saddle investors with unnecessary losses.

A stop-loss order instructs your broker to sell your position in a stock once the shares hit a certain price. For example, if you own a stock trading at $100 per share and want to limit your downside potential to about 10% of your initial investment, you might set a stop-loss order at $90. In the event that the stock price hits this threshold, your broker will sell the position at the best price available.

This risk-management strategy sounds perfectly reasonable: There’s an old saw on Wall Street about cutting your losers short and letting your winners run. A stop-loss order takes emotion out of the equation and can prevent you from taking a big loss if you’re not watching the market’s every tick.

But this strategy can blow up in your face.

Consider Home Depot’s stock, which finished Aug. 21 at $116.16. Many individual investors probably set their stop-loss orders near obvious levels of technical support—in this case, the 200-day moving average of about $110 per share. Other popular options include somewhere in the neighborhood of $105 per share, the stock’s May 2015 low. Looking back even further, the chart shows additional signs of support between $94 and $100 per share.

(Click image to enlarge.)HD August 21 Elliott Gue

Any of these stop-loss orders would have been triggered when Home Depot’s stock opened the Aug. 24 trading session at $110.05 and plummeted to $92.16 within 3 to 5 minutes.

In other words, the stop-loss orders instructed brokers to sell the stock at the worst possible time—during a wave of selling activity.

In rapidly moving markets, a stock can drop by several dollars before your stop-loss order is actually executed. For the three minutes after Home Depot’s shares slipped to $108.50, the stock’s average volume-weighted price was $99.93 per share.

A stop-loss order at $95 per share would have been even worse. About 205,000 shares of Home Depot traded for less than $95.50 on Monday, Aug. 24, all in the first 5 minutes of trading. The average execution: $92.88, down roughly 20% from the prior Friday’s close.

As painful as the collapse in Home Depot’s stock proved for investors with stop-loss orders, the stock’s rapid recovery added insult to injury. Between 9:35 a.m. and 9:45 a.m., more than 1.01 million shares of Home Depot changed hands at an average price of $109.58.

Hedge funds and other active traders take advantage of these obvious stop-loss levels to swoop in and pick up shares of Home Depot and other high-quality fare at bargain prices.

Although setting a stop-loss order might make sense for a higher-risk stock, indiscriminately using this risk-management strategy on high-quality names is ludicrous and dangerous to your wealth in a volatile market.

Some popular investment newsletters suggest stop-loss levels to readers, even on high-quality names such as AT&T (NYSE: T) and Verizon Communications (NYSE: VZ)—companies that generate huge streams of free cash flow and pay ample dividends, regardless of where we are in the economic cycle. Guidance of this sort is downright dangerous to your wealth.

Instead, use other investors’ bad judgment to your advantage.

In Conrad’s Utility Investor and Energy & Income Advisor, we periodically publish a list of dream buy prices for our favorite stocks, names that we would hold through thick and thin. By setting buy limit orders at these levels, investors can take advantage of these short-lived collapses to establish or add to positions in high-quality names. Such a strategy would have paid off in spades last Monday.

Don’t be a victim of market panics like the one that transpired last Monday; an ounce of preparation can lead to significant profits.

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