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Our New Low Observer team is quite skeptical when it comes to strategies that are supposed to "protect" the investor from risk of loss. Such strategies as the use of stop orders, limit orders, and the many variations on the theme are supposed to protect an investor if their long-term holding of a stock suddenly declines to a level which would either generate a loss or significantly reduce a profit. Unfortunately, none of these "tools" will save a small investor when the market or an individual stock is under significant strain.

On Thursday May 6, 2010, we were given a prime example of why we are against using "protection" strategies offered by your broker to mitigate losses. The kind of collapse and recovery that was seen on May 6th occurs more frequently than most people think. While I admit that few stocks go from $40 to a penny (...or $0.0001 as one of my stock alerts from my broker told me) and then back to $40 in one day like Accenture (NYSE:ACN) did. Many stocks drop 15% to 20% in a single day based on a larger than expected loss or missing their earnings target by a penny (that infamous penny again). Depending on the quality of the stock, in most cases, the price recovers the losses quite quickly in a matter of weeks or months. Since most people claim to be long term investors, automated orders force small investors out of a stock at unreasonable prices.

Some investors have explained that it is foolish not to use a stop loss order because they protect from losing "too" much. After all, wouldn't an investor want to get out of Procter & Gamble (NYSE:PG) (no pun intended) if it was bought at $60 then climbs to $62 and then falls all the way down to $55 during market hours? Under normal market conditions I would completely agree, however...it is safest to assume that there are never "normal" market conditions. On May 6th, Procter and Gamble essentially recovered all of the losses except the 3% that was on par with the market indexes at the close for the day. If you had a trailing stop loss at $60 then more than likely you would have gotten out of PG at or near the lowest price if you held 1000 shares or less.

As any regular reader of our site knows, when we issue sell recommendations, we are specific in indicating that stop orders etc... are not to be utilized when selling a stock. Our boiler plate language for every sell recommendation is as follows:

It is always recommended that when selling a stock, one should not place stop orders, limit orders or orders after hours. This leaves the seller in the position of being vulnerable to the whims of the market makers. Instead, place your sell orders only as a market order during market hours. Some would complain that a market order during market hours might leave some profits on the table. However, we would rather leave some money on the table rather than have it taken away from us by the trades that are placed by institutions and market makers.

Most uninformed or new market participants would like to blame computers trading for the rapid sell-off in stocks. However, stock market history suggests that market imbalances are as old as the day is long (this explains why "money" dominates the exchanges of goods and services instead of barter). There is ample evidence from all previous market panics in history to point out who gets the short end of the stick under "fast" market conditions. The use of protection strategies like stop loss orders, etc... usually doesn't work for small investors when it is needed the most.

The explanation of the reason why protection strategies don't work is simple and I'll do my best to articulate the concept. When an automatic order is triggered, the sale or purchase of a stock is triggered. However, if you are a small investor, your order to sell 100 shares does not get priority over the single order to sell 1 million shares. If you're a market maker, you're going to be forced to create a market for the million shares even though there are enough small trades equal to 1 million shares to match. However, it is less work and more efficient to match up the large orders first and then worry about the small orders later. It's like having $8 in cash to pay for your items at the grocery store. Five dollars are in ones and the rest is in pennies. Does the clerk start counting the pennies first or the dollar bills?

Naturally the million shares and others like them get priority to be cleared from the stock exchange thereby getting preferential pricing instantaneously. Sitting on the sidelines are the small trades that need to be matched up. However, if your 100 share automatic sell order has to wait for multiple million share orders to clear first, then by the time your order is ready to be placed the price of the stock would have fallen well below your original limit price. In some instances, I've seen where the smaller trades are executed 40% below the original trigger. The opposite is true of automatic orders to purchase stocks resulting in the all-too-familiar decline in the stock price immediately after the small investor buys.

We don't know how long it will take for small investors to realize the risk of automatic orders. Our position on this matter remains clear, automatic orders are fraught with problems with little in the way of recourse for an unlevel playing field.

Investment Notes:

Disclosure: No positions

Source: Automated Orders Don't Provide Protection