Ask Colin

Why don't you use automatic stop orders?

The detailed question was in the context of my sale of RCG Corporation (see the Stock Investment Journal on the members website):

I wonder why you do not use ‘conditional sell orders’. Is there a reason? I wonder why you choose to do it yourself knowing that there would be a situation like this time that you are away or some reasons that you do not realize the hard sell-stop was triggered. By the time you realized the hard sell-stop was triggered the price dropped very hard and went down much lower than the hard sell-stop, do you sell it with the very low price immediately? or wait? or any action you would do? 

 

There are a number of issues here:

  1. With smaller stocks like this one, at least relative to my order size, an automatic stop might have to move the price a long way down in order to fill the stop order. This is even more of a problem in recent years because so little of the real buying volume is actually in the market. Larger buyers break their orders down into small chunks and only put some of it in the market in order not to disclose their order. Once the part in the market is filled, they put some more there. They are able to do this automatically using algorithms. Smaller buyers may also only put part of their order in the market, but they manage it manually. This situation is ripe for a stop order to trigger a cascade of sales lower and lower and may make it worse by triggering more stop orders on the way down.

  2. So, I prefer to manage my sell orders manually. I don’t split them, but I use limit orders so as not to cause a cascade lower trying to fill a market order. I also have two portfolios. They are of similar size, the slightly larger one being the SMSF portfolio I show on the members website. The other portfolio is outside the superannuation system (I do not want all my capital tied up in the superannuation system in case the government changes the rules to make it harder to get funds out). Both portfolios hold the same stocks in the same proportions, so the SMSF portfolio on the website mirrors it. Because they are legally in different names, when I buy or sell I have to place two orders. I am not comfortable with exactly what would happen with two automatic stops – which one would go first in the broker’s system (I am not sure there is a way I can control it)? On balance I feel happier managing the stops manually.

  3. In the case you mention, my orders were far larger than any volume shown on the depth screen near the last transaction price. However, there had been several times my total order size transacted on a typical recent day. So, the volume was there, but not on the depth screen. So, I placed two limit orders at $0.60 and left them there. The price went lower soon after, but I did not chase it and just left the orders in place for a few hours. When I came back they had been filled. What is required is judgement, patience and discipline.

  4. Every situation is different and requires a judgement on just how critical it is to act quickly. This comes to the second part of your question. The stock had closed the day before at $0.695. My hard stop was at $0.63. On the day it fell through my stops it had traded in the range $0.66 to $0.56 and closed at $0.61. So, it had closed two cents below my hard stop. The stock had therefore not fallen dramatically and was not still falling “like a stone” that might prompt really urgent execution of the order. I calmly put my orders in the market and waited for a fill as described above. In my position size calculation, I had risked 0.30% of capital back to my hard stop. My actual loss was 0.32% of capital. The price drop was modified by a dividend and franking credit paid while I owned the stock. So, in most respects this exit was rather boringly routine and nothing to panic about.

  5. I do not use borrowed money to invest. Nor do I use any leverage instruments, I buy fully paid shares. If you are using leverage e.g. CFDs or if you have a margin loan, that situation becomes more critical in that it is possible to lose a lot very fast, even more than you invested. If I were using leverage, I would probably have an automatic stop in place.

  6. I also advocate automatic stops for beginners who have not yet developed the discipline to act on stops unemotionally and without hesitation. I would also not recommend that they invest in smaller stocks because they are more dangerous and require greater experience and skill to manage. Moreover, they are not suitable for automatic stops because there is not enough depth in the market.

Something of an overlay on this is that for 23 years (till 1987) I was an investor with a full-time day job. Automatic stops were not possible and I could only check the market after hours. This meant that I developed a style of investing that allowed me to act next day when stops were hit. Things were very different then, everything was done by telephone – the internet was still over a decade in the future and online broking came a while after that and automatic stops have only been possible more recently. So, my attitude to stops above does reflect my investment style that developed in a different age.   

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