A stop-loss order is a method used to mitigate risk by automatically selling a stock should its price drop below a predetermined level. The hazard occurs during periods of extremely high volatility (ie market corrections) when a “flash crash” is likely to happen.
For example, during this week’s correction many ETFs and even highly rated stocks experienced EXTREME intra-day price volatility (ie flash crash). DVY is a high quality, dividend paying ETF that might be owned by a conservative investor looking for growth with income. It’s highly liquid, pays a 3.4% dividend and generally is very stable with a beta of 0.82. In the below chart, you can see the relative stability over the past three months (each hash mark represents the daily price range). However, on 8/24/2015 the price plunged over 35%, experiencing an intra-day flash crash.
A stop-loss order wouldn’t have mitigated risk in this situation, in fact that’s what most likely triggered the event. Many investors probably had their position protected with a stop-loss order set to execute should the price drop more than 5%. Once the large quantity of sell orders began to execute, prices rapidly plunged (because there many more sellers than buyers).
The price eventually stabilized (once the computers stopped executing all the sell orders) and the stock ended the day with only a 3.8% loss. HOWEVER, investors that relied on a stop-loss most likely lost 10-35% during the 20 minute flash crash. Thus illustrating the point that stop-loss orders don’t guarantee a specific sell price, they simply ensure the stock will be SOLD at the prevailing market price.
BOTTOM LINE- don’t rely on stop-loss orders during periods of high volatility.
[ETFs are more susceptible to flash crashes because of slow response from authorized traders (market makers) but all stocks are vulnerable. P&G plunged 9.5% intra-day on 8/24/2015.]
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