Stop Loss Orders May Lock In Losses When Stocks Plunge in Volatile Markets

When RJ Parsons put stop-loss orders on his 5,000 shares of MannKind Corp., he thought it would protect him from losing a chunk of his investment.

“That was about a $12,000 mistake for me,” the 59-year- old retired military officer from Malibu, California, said in a telephone interview last week. MannKind dropped 38 percent within minutes on Jan. 19, five hours before the biotechnology company failed to win approval for a diabetes treatment.

Stop losses are orders to sell when a stock’s value drops to a specified price. Many U.S. investors like Parsons use them to protect gains if they go on vacation for a few days, for example, or don’t monitor their holdings regularly, said Randy Frederick, director of trading and derivatives for San Francisco-based Charles Schwab Corp. with 8 million brokerage accounts. They often don’t understand how dangerous it may be to rely on them, said Frederick.

That’s because stop losses may be executed before a stock rebounds when there’s abnormal trading. The shares also might be sold at the next available price, which may be far lower than expected, said Frederick, who’s based in Austin, Texas. They’re especially dangerous when a stock closes at one price and opens lower the next trading day due to news that breaks overnight or during a weekend, Frederick said.

Market volatility over the past two years such as the decline on May 6 that briefly erased $862 billion in value from the equity market in about 20 minutes is even more of a reason not to use stop losses, said David Donabedian, chief investment officer for Atlantic Trust Private Wealth Management in Baltimore.

Bounce Back

“A staggering total of more than $2 billion in individual investor stop loss orders is estimated to have been triggered during the half hour between 2:30 and 3 p.m. on May 6,” U.S. Securities and Exchange Commission Chairman Mary Schapiro said in a Sept. 7 speech in New York. “The broad market indexes dropped more than 5 percent in five minutes, only to rebound almost entirely in the next 90 seconds,” Schapiro said.

In Parsons’s case, he had a stop-loss order at $7 on 2,000 of his MannKind shares, which he bought at $8.50 through his online brokerage account with Boston-based Fidelity Investments, he said. When MannKind, based in Valencia, California, fell to as low as $6.05 at 10:36 a.m. New York time from $9.37 within a minute, Parsons’s position was sold. The stock bounced back to about $9 by 11:57 a.m. when Nasdaq OMX Group Inc. halted trading through the 4 p.m. close of U.S. exchanges that day because of “news pending,” according to data sent to Bloomberg.

“Poof, it was gone,” said Parsons, who said he’s a real estate investor and entrepreneur. “I’ve been to Vegas with some fast company but this was pretty fast.”

‘Removes Judgment’

Parsons then placed another stop loss order at $9 to protect gains on his remaining 3,000 shares, he said. MannKind announced around 3:30 p.m. on Jan. 19 that the company failed to win approval from the Food and Drug Administration for its inhaled insulin. The stock plummeted as much as 45 percent in late trading and when the market opened the next day, Parsons said his shares sold at $5.07, or $4 less than his specified price.

“They remove investment judgment from the equation,” said Donabedian, who generally advises his clients against placing stop loss orders on shares. Atlantic Trust, based in Atlanta, has more than $16 billion in assets under management. Investors don’t always get the price they want and may lock in a loss before a stock rebounds for a “double whammy,” he said.

Another Tool

Stop limits are another tool traders use, said Gregg Murphy, senior vice president of retail brokerage at Fidelity, which has 12.7 million retail brokerage accounts. These orders guarantee a price but not an execution of the sale, he said. They may not provide greater protection than stop losses because if a stock falls below the limit before it’s sold, investors may be stuck with the security, Murphy said.

Diversifying your portfolio is one way to mitigate risk without a stop loss or limit, said Pamela Rosenau, managing director and equity-market strategist for Chicago-based HighTower Advisors. “You don’t want to have over-sized positions,” in one stock, said Rosenau, whose office is in New York.

Rosenau, who manages about $703 million of client assets, also says she watches the fundamentals of a company rather than market swings when deciding whether to sell. “If they deteriorate, I’m out,” she said.

Investors may also use options to hedge risks against declines, said Schwab’s Frederick and Fidelity’s Murphy. Options are contracts that grant buyers the right, without the obligation, to buy or sell a security at a set price. Unlike stop losses and limits, they cost money. One put option giving an investor the right to sell 100 shares of a security, for example, costs $7.95 for the commission and 75 cents for the contract, Murphy said.

Insurance Policy

“It’s like an insurance policy, so if you don’t need it, you end up spending money on it anyways,” because the option has an expiration, said Frederick.

“Let’s say I owned a $9 put option and the stock drops to $6. I can call my broker and say I want to exercise the put option, in which case I’m able to force my stock on somebody else at $9 a share,” Frederick said.

Schwab doesn’t track the frequency or volume of stop loss orders, said spokesman Neil Shapiro. Fidelity also couldn’t provide data, said spokesman Stephen Austin.

Stop losses may work in markets that are slowly declining because orders may get filled relatively close to their trigger prices, said Schwab’s Frederick.

Parsons, the MannKind investor, said he presumed his stop losses were in place for normal trading. More should be done to protect investors from extreme price drops and rebounds within minutes as a result of electronic trading, he said.

‘Something Going On’

“I really think that there’s something going on that the average investor is going to get more concerned about,” he said of volatility in the stock market.

Nasdaq spokesman Wayne Lee declined to comment in an e-mail as to whether the exchange is currently investigating irregularities in MannKind’s trading. Exchanges, working with the SEC, have created a number of safeguards for investors since the May 6 crash, including harmonizing rules for canceling trades and pausing trading if a stock moves 10 percent or more in a 5-minute period, said Ray Pellecchia, a spokesman for NYSE Euronext in a telephone interview.

To contact the reporter on this story: Margaret Collins in New York at mcollins45@bloomberg.net.

To contact the editor responsible for this story: Rick Levinson at rlevinson2@bloomberg.net.

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