The Danger of Stop-Losses

Setting stop-loss orders is a common thing to hear about if you’re investing money in stocks. For those unaware, it’s the act of setting a lower price-boundary at which the stocks you own will automatically be sold if they hit them.

As an example, say you own shares of Company ABC at S$10. To prevent yourself from suffering a loss of greater than 10%, you had set a stop-loss order at S$9. In this way, the maximum loss you’d make if ABC’s shares were to fall one day would be 10%. Your losses will be stopped – hence the name, stop-loss orders.

That sounds nice in theory. But as Yoggi Berra once said, “In theory there is no difference between theory and practice. In practice, there is.”

If you look at the price chart below for cashless payments processor Visa for Monday night, you can see a sharp decline followed swiftly by a violent spike (see red bubble).

Visa price chart

Source: Google Finance (click for larger image)

Visa closed last Friday at US$71.19. At its low on Monday, Visa was trading at US$60.00. Guess where it ended on Monday night, just mere hours after reaching the low of US$60? US$68.36.

Investors who had set stop-loss orders in the neighbourhood of US$60 for Visa would have seen their shares being sold and thus lose the opportunity to participate in the quick rebound.

Visa’s price action on Monday night was not an isolated incident. There were many other U.S. stocks that had similar movements that day. Such erratic price actions had also happened before with the Flash Crash of May 2010 being a good example.

In other words, the stock market can have random episodes of insanity where prices swiftly (in a matter of hours or minutes) deteriorate to a level that is completely detached from where economic fundamentals would suggest. For investors with stop-loss orders, such instances may result in unnecessary losing trades being made and cause a ding to their portfolio.

As far as I know, there were no such instances of a brief flight into madness for Singapore’s stocks on the few days before and after the Visa incident happened. But, that doesn’t mean it won’t in the future.

I’m not here to criticise stop-loss orders – they can have useful functions. But investors in Singapore need to be aware of the risks involved.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.