Stop-Loss Orders

Stop-Loss Orders have always seemed completely insane to me. They completely ignore fundamentals; they are set according to price only.

If you’re willing to sell something at $20, why wouldn’t you sell it at $21 when you have the chance? The deliberate introduction of negative convexity into a portfolio – without getting paid for it! – is something that has bothered me even before I could express the idea in terms of convexity.

I was asked a question regarding Stop-Loss orders recently, which I answered as politely as I could; but it would be helpful to have some academic references to buttress my biases … or, who knows, maybe even refute them, although that would be the complete antithesis of how I have managed money throughout my career.

So … I’m starting this post to keep my notes in. Carry on!

Positive Feedback Investment Strategies and Destabilizing Rational Speculation, J. Bradford De Long, Andrei Shleifer, Lawrence H. Summers and Robert J. Waldmann. Yep, that’s THE Larry Summers. Anyway, the argument here is that there will be a certain proportion of “positive feedback” traders in the market, no matter what – they might even be margin traders, getting margin calls in a down market. Therefore, it becomes rational for informed traders to overreact to actual news, because they know that uninformed traders will overreact even more while the informed traders liquidate. While interesting, the authors are more interested in demonstrating the variability of the market and determining “critical points” – where a decline becomes a discontinuous crash – rather than looking at empirical evidence of stop-loss profit-and-loss.

Market Liquidity, Hedging, and Crashes by Gerard Gennotte and Hane Leland has much the same theme. There’s a nice line in the conclusion: “Traditional models which do not recognize that many investors are poorly informed will grossly overestimate the liquidity of stock markets” …. I’ll have to think about how that might tie in with the Credit Cruch!

One Response to “Stop-Loss Orders”

  1. […] former noteholders elect to sell their shares at the market, the effect can be modelled as a stop-loss order; such orders have been suggested as a factor in the May 6 market bungee-jump even though the […]

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