How Can a Stop-Loss Order Fail?

A stop loss order puts an immediate sell order on shares of a security that fall below a certain price. Since the order is executed automatically, the order cannot "fail" to be executed if the stock hits a given price. It can fail to deliver the best possible outcomes for the portfolio, however, and this is the main reason some analysts advise against using stop loss orders too heavily. Their reasons are varied, but they often focus on proper market responses versus improper responses.

"Getting Out" vs. Getting Back In

A stop loss order can be placed only to order the sale of the security. It does not advise on the proper time to get back into the market. In many studies, analysts show that individuals who sell shares through a stop loss order remain out of the market too long. They do not keep up with trends, and by the time they are back in securities, the securities have already risen beyond an advisable point. This means the individual would have turned a higher profit by simply holding onto the stock and waiting out the dip. This is particularly true in a highly volatile market, where the dip is more likely to be downward than upward. By selling and exiting the marketplace, the investor loses money only due to volatility and misses opportunities to gain.

Diversifying Properly

Some analysts point out that diversification is necessary but should be used properly. By completely hedging against risk with stop loss orders and other techniques, the investor may create a situation where he or she is actually hedging out of potential gains. The result is only modest, predictable returns instead of actual capital gains and growth. For example, analysts recommend selling some bonds and purchasing more marketable securities if the market has fallen. This is slightly riskier, but it can present opportunities for gains where bonds would not. The proper response is not to get out of securities altogether, which is what a stop loss order on too many stocks would do.

Delays in Sales

One scenario where a stop loss may actually fail occurs in a highly volatile market where there is a dramatic and unpredictable dip. If too many individuals holding one stock attempt to sell, perhaps on account of a stop loss order, the stop loss will not be executed automatically. This brief delay between the order and the time the stock is actually sold can create a scenario where an even greater loss occurs. Many analysts blame this scenario for the market dip in 2007. So many individuals instinctively sold stock and exited the market that they lost money even on their stop loss orders. They lost so much, they were afraid to re-enter the market in the near future. The problems that then occurred were further dips, slower drags to recover, and deeper losses for those who still owned securities. The systemic problems to the market were a good example of how stop loss orders can actually increase risk instead of hedging against it.

blog comments powered by Disqus