R.J. Parsons put stop-loss orders on his 5,000 shares of MannKind Corp. (MNKD) thinking they would protect him from losing a chunk of his investment
R.J. Parsons put stop-loss orders on his 5,000 shares of MannKind Corp. Ticker:(MNKD) thinking they would protect him from losing a chunk of his investment.
“That was about a $12,000 mistake for me,” said the 59-year-old retired military officer. MannKind dropped 38% within minutes on Jan. 19, five hours before news broke that the biotechnology company had failed to win approval for a diabetes treatment.
Many investors use stop-loss orders, which kick in when a stock's value drops to a specified price, to protect gains if they go on vacation for a few days or if they don't monitor their holdings regularly, said Randy Frederick, director of trading and derivatives for The Charles Schwab Corp. But investors often don't understand how dangerous relying on stop-loss orders can be, he said.
That's because stop losses may be executed before a stock rebounds in abnormal trading. The shares might be sold at the next available price, which may be far lower than expected, Mr. Frederick said. The orders are especially dangerous when a stock closes at one price and opens lower the next trading day because of news that comes out overnight or over a weekend, he said.
While stop-loss orders are intended to protect investors from price declines, the increased market volatility of the past two years — underscored by the May 6 flash crash, which erased $862 billion in equity value in about 20 minutes — has made their use much riskier, said David Donabedian, chief investment officer for Atlantic Trust Private Wealth Management.
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,” Securities and Exchange Commission Chairman Mary Schapiro said in a Sept. 7 speech.
“The broad market indexes dropped more than 5% in five minutes, only to rebound almost entirely in the next 90 seconds,” she said.
Mr. Parsons 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 Fidelity Investments, he said. When MannKind fell to as low as $6.05, from $9.37, at 10:36 a.m. Eastern time, Mr. Parsons' position was sold within a minute.
“Poof, it was gone,” said Mr. 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.” The stock bounced back to about $9 by 11:57 a.m., when Nasdaq OMX Group Inc. halted trading due to “news pending.” Trading remained halted through the 4 p.m. close of U.S. exchanges that day.
Mr. Parsons then placed another stop-loss order at $9 to protect gains on his remaining 3,000 shares, he said. On Jan. 19, MannKind announced at around 3:30 p.m. that it had failed to win approval from the Food and Drug Administration for its inhaled insulin. The stock plummeted as much as 45% in late trading, and when the market opened the next day, the shares sold at $5.07, nearly $4 less than his specified price, Mr. Parsons said.
Schwab doesn't track the frequency or volume of stop-loss orders, spokesman Neil Shapiro said. Fidelity also couldn't provide such data, spokesman Stephen Austin said.
Stop losses may work in markets that are slowly declining, because orders may get filled relatively close to their trigger prices, Mr. Frederick said.
“They remove investment judgment from the equation,” said Mr. Donabedian, who generally advises his clients against placing stop-loss orders on shares. Investors don't always get the price they want and suffer a “double whammy” when they lock in a loss before a stock rebounds. Atlantic Trust has more than $16 billion in assets under management.
Mr. Parsons 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.
“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 as to whether the exchange is 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% or more in a five-minute period, said Ray Pellecchia, a spokesman for NYSE Euronext.
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, which guarantee a price but not an execution of the sale, may not provide greater protection than stop losses because if a stock falls below the limit, investors may be stuck with it, he said.
Diversification is one way to mitigate risk without a stop loss or limit, said Pamela Rosenau, managing director and equity-market strategist for HighTower Advisors LLC. “You don't want to have oversized positions” in one stock, she said.
Ms. Rosenau, who manages about $703 million of client assets, said 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 also may use options to hedge risks against declines, said Mr. Frederick and Mr. Murphy. Unlike stop losses and limits, however, they cost money. One put option giving an investor the right to sell 100 shares of a security, for example, costs $7.95 in commissions and 75 cents for the contract, Mr. Murphy said.
