Topics:Investing Ideas & Strategies
John Gabriel, On Wednesday May 12, 2010, 7:00 am EDT


The dust is still settling and fingers are still being pointed in the aftermath of what is now being called the "flash crash." Sorting out the mess will require much time and likely result in more fingers being pointed in multiple directions, but we simply have to accept the fact that markets will occasionally suffer bouts of extreme volatility--and be properly prepared to ride those waves until calmer waters prevail.

While at this point there seems to be more questions than answers, we can't help but feel for some of the unsuspecting victims of this erroneous market action. But the first step in avoiding disasterous results in the short term is to avoid taking potentially perilous actions. Followers of Morningstar's exchange-traded fund research are more than likely familiar with our strong preference toward using limit orders when executing ETF trades. This helps ensure that you get a price at or extremely close to the fund's net asset value. After all, in a properly functioning market, a fund is worth simply as much as its constituent parts. If you are selling and not getting something very close to fair value, we would recommend not selling at all.

One type of trade that we vehemently avoid more than any other is known as a "stop-loss" order.

Our main problems with this statement are that it is blatantly false, imparts a false sense of security, and can lead to truly disasterous results.

Such misinformation likely makes employing a stop-loss strategy sound appealing to a risk-averse investor who cannot actively monitor his portfolio. In the case of a traditional stop-loss order, once the "stop" price is reached, a market order to sell the security is entered. Hence, the trade will be made but not necessarily at or near the predetermined stop price. As was the case last Thursday, if there is insufficient liquidity or the market is moving quickly, there's a good chance that the order could fill at unfavorable prices.

In order for a fund to trade near net asset value, the prices of all of the individual securities in a fund must be known. A mutual fund accomplishes this by waiting to the end of the day. This periodic pricing masks the intraday volatility. There is little risk for the mutual fund company because all of the prices at the end of the day are known. But for an ETF, which trades throughout the day, waiting until the end of the day to set a price is not possible. Instead, the ETF depends on arbitrage. In order to keep the price trading near net asset value, a trader needs to be able to quickly calculate the net asset value. The magnitude and urgency of the calculations lends itself to electronic and algorithmic trading.

When volatility increases, so does the uncertainly of the net asset value. In response, a market maker is going to widen out his bid-ask spreads and reduce trading until after making an assessment of market activity. The market makers and algorithmic traders are using sophisticated order instructions. They are not going to make market orders when they have no idea where the market is. As an individual investor, we need to be aware of when our trades are going to be executed and at what price. After all, a stop-loss order is a very unsophisticated form of algorithmic trading. It becomes a market order precisely when volatility has increased.

To paraphrase Peter Lynch, if you buy a stock with a stop-loss of 10%, the only thing you are guaranteeing is that you'll lose 10% on that trade. We couldn't agree more. In fact, we often quip that a more appropriate name for stop-loss order would be guaranteed loss order. Those of us who experienced the violent volatility that was so prevalent at the height of the credit crisis should also agree with Lynch's point of view on the matter.

Of course, there are likely many investors/traders who swear by the use of stop-loss orders. A popular strategy we've started to hear more of as people dip their toes back into the market is the use of trailing stop orders. Such dynamic orders are used with the intention of maximizing profit when a security's price is rising and limiting losses when it falls. For example, a $1 trailing stop on a $20 security would be triggered if the price fell to $19 or below. However, if that security were to rise to, say, $25 (without breaching the $1 trailing stop) then the stop price would reset to $24, thereby helping the investor "lock-in profits."

Frankly, if you have such little confidence in your investment, you probably should not own it in the first place. But if utilizing stop-loss orders is something you're comfortable with as part of your investment strategy, we'd simply advise that you make sure to use limits. There are "stop-limit" orders and "trailing stop-limit" orders available. While just placing a stop-loss order will trigger a market order, these stop-limit orders will result in limit orders being placed if the predetermined price is breached. This can mean a world of difference in erratic and volatile markets.

Consider the hypothetical investor who had a 10% stop-loss on an ETF sitting out on the market last Thursday when things went haywire. As soon as the 10% decline was registered, there would have been a simple market order entered for that investor to sell his shares. Because the NYSE went into "slow mode" in order to step back and try to make sense of the chaos, trades spilled over into other exchanges in search of "bids" (courtesy of Regulation NMS). When the NYSE slowed, it shifted to 30-second or one-minute intervals, as opposed to the fractions of a second we'd typically see under "normal" market conditions.

The problem was that the NYSE was the only exchange to go into "slow mode." What happened was there was a large influx of sell orders but very few buy orders. In between these slowed intervals at the NYSE, the market sell orders (which had no specified "ask" price) went out onto other exchanges looking for bids to hit. Unfortunately, during this (very short) chaotic period, many market makers widened their bid-ask spreads enormously until they could figure out what was happening. In effect, the market makers were stepping away from the market. However, the market sell orders coming through the system were looking for bids to hit, regardless of how erroneous they were at that given instant.

The result was the malaise witnessed last Thursday--ETFs representing ownership of hundreds of stocks trading down 60% or more from the prices they were traded at less than an hour before. In our example above, what was supposed to be a limited loss of 10% essentially turned into a loss of 60% to 100%, and most of those losses were recovered in a matter of minutes for those who wisely held their postitions. This happened because there weren't any "real" bids at that moment in time. One moral of the story is to avoid using market orders. Moreover, it always pays to know what the value of your investment is at any given time. Thankfully, with ETFs you can always check the intraday indicative values, which are published every 15 seconds throughout the trading day.

Createwealth8888:

Stop Loss

Stop loss is when you pre-determine your own exit price to take the loss and walk away. It is just one of those bad trades and it is not that painful as the loss tends to be smaller.

Cut Loss

Cut loss is different from Stop Loss. Cut loss is when you felt so hopeless at the falling stock price and it has reached your threshold of pain. You bite your finger and sell it and move to the sideline for a while.  Cut loss is usually bigger and more painful.

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BT, Wed, May 26, 2010, Singapore

Resisting the urge to sell low


When stock markets lurch, hasty decisions taken at anxious moments can be extremely costly to investors


IF you've got money in the stock market, take a deep breath: It's one of those moments. The market is lurching, and that is precisely when impulsive behavior can hurt the most. Investing can be a delightful pastime when stocks are rising. When they are falling - which has often been the case lately - it can be excruciating. But hasty decisions taken at anxious moments can be extremely costly.

'When a lot of people reach their threshold of pain, they sell their stocks and try to move to more secure holdings.'

'When a lot of people reach their threshold of pain, they sell their stocks and try to move to more secure holdings - cash, bonds, Treasuries,' said Louis S Harvey, president of Dalbar, a fund research firm in Boston. 'These decisions don't work out very well for most people.' Over the long haul, the average investor has badly underperformed the overall stock market: Through December, over the last 20 years, the average stock fund investor has had annualised returns of only 3.2 per cent, compared with 8.2 per cent for the Standard & Poor's 500-stock index, according to Dalbar. Short-sighted moves in down periods account for much of the deficit, Mr Harvey said.

Lately, anxiety among investors undoubtedly has been rising. The flash crash of May 6 - the biggest intraday swing in market history - didn't help. Shortly after 2.30pm that day, the Dow Jones industrial average fell 1,000 points - and then came most of the way back, all in a matter of minutes.

The causes of that sharp drop aren't yet entirely clear, although they appear to be related in part to glitches in the connections of lightning-quick computerised stock trading across the United States.

In response, the Securities and Exchange Commission (SEC) last week said it would temporarily impose 'circuit breakers' on stocks in the S&P 500 when they have fallen 10 per cent or more in a five-minute period. The SEC and the Commodity Futures Trading Commission say they are still studying the crash, but don't yet understand it. And then there's the Greek crisis. Since the announcement of a nearly US$1 trillion bailout package for Greece and other fiscally strained eurozone countries, turmoil in global markets has not abated. Despite an upturn on Friday, stocks have been choppy; the dollar, Treasury bonds and gold prices have risen; and oil and the euro have plummeted.

Professional asset managers have been responding as best they can.

Robert C Doll, vice-chairman and global chief investment officer for equities at BlackRock, the investment management firm, says he thinks the American market is likely to remain relatively volatile for an extended period - and then resume its climb.

In addition to the angst caused by the flash crash, and the problems in Europe, Doll points to the bear market in China and the threat of economic slowdown there, as well as domestic issues in the United States. These include continuing uncertainty about regulatory reform, investigations into the activities of Goldman Sachs and other banks, and the unsettled state of the American economy. He says two other 'scenarios' are possible, but much less likely.

One is a global meltdown, with the Greek crisis morphing into 'Lehman II', the probability of which has been reduced by prompt action by European authorities. And the other is a quick resumption of the roaring bull market that took the S&P 500 up 80 per cent. But there are too many problems for that to be very likely in the next month or two, he said.

For long-term diversified investors, he said, it probably makes sense to ride out the storm, and, maybe, add to your holdings. 'Keep your shoulder harness on, and your seatbelt secured, and your life should be OK,' he said.

There are even reasons to be encouraged by the health of the global economy, said Larry Hatheway, chief economist and chief strategist at UBS Investment Bank. While he acknowledged the negative effects of the 'sovereign debt crisis' in Europe and myriad problems elsewhere, he also said: 'Signs of growth are very strong and incoming data is beating expectations, and this is true in all major economies, in all major regions around the world.'

Corporate profits are surging, Mr Hatheway said. Firms that cut costs in the recession are reaping immediate bottom-line benefits as revenue rises in a global recovery. And, finally, he said, central banks in Europe, the United States and Japan have kept short-term rates 'extraordinarily low, near zero.' 'We've got low rates, strong profits and strong growth,' he said.

'That's a pretty powerful combination to boost stock prices.' It makes sense for big institutions to engage in tactical manoeuvres - buying stocks that seem cheap because of a market drop, for example, and emphasising sectors that may benefit from economic shifts, said Derek L Young, chief investment officer at Fidelity's global asset allocation group. Fidelity is analysing the implications of a possible 'prolonged period of weakness in the eurozone'.

One thing you don't want to do, he said, 'whether you're a professional or an individual investor, is to make an emotional judgment about the marketplace.' - NYT


"When you are emotional, you make unwise decisions rapidly." - Warren Buffet

Read? Stop loss or Cut loss?

By Philips Loh, invest, Nov 21, 2010, the sundaytimes

Some key points noted in the articles:



      'buy low, sell high' tactic

• Qualities of a good investor - The most successful investors are those who are able to overcome their innate fear and greed during wild market gyrations, and discern real risks, as opposed to perceived ones. They have a keen awareness of their limitations and predictive powers.
• Associating the wrong reasons with a profitable trade can be damaging to our investment quotient in the longer run.
• We must not forget that the markets are full of predatory players who make a living out of having small investors for lunch. These professionals do so well because they are experts at tricking retail investors into reaching wrong conclusions. Therefore to do well in the investment game, investors must be keenly aware of their instinctive ability to detect a pattern and react accordingly, overcome this instinct. Only then can they raise the probability of scoring gains in the game.