Despite the strongest September in nearly 70 years, the market has yet to recover to its early-May levels – the area at which stocks were trading before the infamous May 6 "flash crash" that took the Dow 1,000 points lower in a matter of minutes. It's been almost five months since this unsettling event, and officials are still looking for a culprit.
Those tracking the Securities and Exchange Commission officials researching the matter say new trading regulations could be announced soon that would hopefully prevent a similar event from transpiring in the future. One professional investor – Joe Saluzzi of Themis Trading – said the regulatory commission could opt to prohibit stop-loss orders (or at least limit the situations in which they can be used).
A stop-loss, also called a "stop order," is an order type that allows investors to close a losing position, possibly limiting losses. A market stop order is simply an order to automatically buy (or sell) a position at the market, once that position has crossed a pre-determined price threshold. A limit stop order has a similar goal but limits the exit to the specified price.
These orders are popular among investors who wish to stay disciplined and cut losing positions or can't actively manage their portfolios on a daily basis. Stop losses are also useful for those who need to set exit points in place ahead of a vacation or other break from the market.
For example, an investor could buy XYZ stock at $100 and establish a stop-loss order at $90, which would theoretically contain losses to 10%. Once XYZ breached $90 – even if it was in the midst of a sharp plunge – the stock would sell at the market price, whether that price was $85, $75, or $50. Meanwhile, a limit stop order might never even be filled if XYZ plunges through the strike.
So there are plusses and minuses for both order types. Everything goes out the window for both order types if selling heats up and the market (or XYZ stock) gaps below the preset level. In a sharp-pullback scenario, it may be virtually impossible to find willing buyers at the $90 level.
On May 6, "as the market melted down," Saluzzi notes, "these [stop-loss] orders were activated and chased prices down a vicious spiral … [they] were not the cause of the flash crash per se, but they resulted in enormous damage to many unsuspecting traditional investors."
So what if this latest speculation becomes reality and stop-loss orders are eliminated (or at least will be used on a limited basis)? How can investors pre-define levels at which they will exit losing trades (or take profits on winning trades)? Will the trader who can't check his portfolio during the day be at a disadvantage?
It's entirely possible that we could see an accelerated move into using options trading to achieve dynamic risk control. With long calls and puts, an investor can effectively limit his or her losses (you can't lose more than the premium paid for long options – plus commissions). Instead of buying Baidu.com (NASDAQ:BIDU) shares for $104 apiece – a net investment of $10,400 for 100 shares – a trader could spend about $1,200 per lot for the January 104-strike call. This gives him the right to buy BIDU shares for $104 but limits his loss to $1,200 (essentially setting a stop loss in place from execution).
If a May 6-type meltdown were to occur again, the stock position could lose much more than that premium. On the upside, long calls (just like long stock) have unlimited upside potential. Drawback: if BIDU is trading at $104 when these options expire, the stock holder is out nothing (other than missed opportunity) but the option buyer has lost the premium paid.
Also, a long stock holder could buy a long put where the strike is equal to the stop-loss price they would have entered. A put gives the right to sell stock at the strike price any time between execution and expiration. Again, the max loss of a long put is the premium paid if the stock remains above the strike price. But a long put coupled with a long stock position will provide the same downside hedge a stop-loss order provided with the added benefit of never being affected by a sudden gap lower like we saw on May 6.
For the bears, the long put strategy could be an alternative for short sellers. Using BIDU as a hypothetical example again, an investor who borrows the stock at $104 has unlimited risk if the stock rallies. A long put, on the other hand, has limited risk and nearly unlimited upside if the stock were to decline. Long options are a wasting asset and if the stock doesn’t move, the option holder will underperform the short stock position.
Just something to consider if regulators clamp down on stop-loss orders. Experiment with a risk-free virtual trading account to play around with long option positions versus their equity counterparts.
Please refer to Characteristics and Risks of Standardized Options, copies of which can also be obtained by contacting our Customer Service Department at firstname.lastname@example.org.