Speaking of trading, I want to talk about certain trading misconceptions. I recently talked about the liquidity trap that some investors were getting themselves into when investing in illiquid stocks. The issue is not an investment issue but a trading issue that can greatly affect the overall IRR. In discussions about this trading trap some other misconceptions came up and I’d like to address one of them: the stop loss order (SLO). In their most basic form these are orders that you give to your broker to sell a security if it drops below a certain price.
The main misconception with SLOs is that when the price of a security drops it will touch every price on the way down. For example, if you bought shares which are now at Dh20 and you put in a stop loss at 19.8 this will not necessarily trigger a sale at 19.8. One reason is that if the last trade is 20 and the next trade is 19.6 then you’ve passed by 19.8. If your broker actually manages to sell at 19.6 you’ve still lost an extra 1 per cent of your position. But there is no guarantee that your broker can sell at the lower price. I recall in mid-1998 that the UAE markets, then trading over the counter (OTC), had been enjoying a great rally when they suddenly collapsed. I saw an order for the most liquid shares at the time, Emaar Properties, executed at Dh160 a share. The crash started the next day and the buyer immediately tried to sell the position. It took several days before a new buyer was found, at a price of Dh40 a share. That is a 75 per cent loss. Remember, this was not about Emaar, the whole market had crashed.
This brings us to the second misconception, that SLOs guarantee size. The first conception showed that even in a liquid market the price can “gap”. The size issue, covered in the liquidity trap, is when the trader holds a sizeable position. I won’t repeat the details but basically if the size of the trading position is large relative to the daily value traded then it is difficult to execute a SLO all at the stop price without adversely affecting the price even further. This is effectively what a portfolio insurance strategy can end up doing and is one of the reasons cited for the Black Monday market crash which led to the largest drop in history of the Dow Jones Industrial Average in percentage terms. The date was October 19, 1987 so its 30th anniversary is a mere three months away. Do you believe in karma?
My rule of thumb is that a 1 per cent position is considered big with 5 per cent considered huge. Huge!
The third misconception has to do with the idea of a stop loss as a risk management system. We’ve already delved into the point that a SLO does not guarantee price or size. But even if it did, SLOs are a tool and in no way represent a risk management system (RMS). For example, the size of each trade is an important element of each RMS. If we assume the existence of a perfect SLO, set at a 5 per cent loss, there is a difference if the position size equals 1 per cent or 20 per cent of the overall portfolio. If the former, we are looking to protect against a 0.05 per cent loss to the portfolio, for the latter it is 1 per cent. There are other more complex issues such as correlation and volatility.
Stops, and similar orders, are useful but their use is limited to a form of support tool when traders are not able to watch the markets, eg when a personal trader goes on vacation. Or perhaps in case they aren’t paying attention. They are certainly not a risk management system.