What is a stop-loss order?
A stop-loss order is a type of order placed with a broker to sell a security when it reaches a certain price. It is designed to limit an investor’s loss on a position in a security. The stop-loss order becomes a market order to sell once the price of the security reaches the specified stop price. Stop-loss orders help investors limit their downside risk when investing in volatile securities or markets.
How does a stop-loss order work?
An investor places a stop-loss order with their broker specifying the security to be sold, the quantity, and the stop price. For example, an investor buys 100 shares of ABC stock at $50 per share. To limit their loss, they place a stop-loss order at $45 per share. If the price of ABC stock falls to $45, the stop-loss order becomes a market order and the 100 shares will be sold at the next available market price. This helps lock in the $5 per share loss on the investment.
Stop-loss orders can be placed as either a stop-limit order or a stop-market order. A stop-limit activates a limit order when the stop price is reached, while a stop-market turns into a regular market order when triggered. Stop-market orders sell at the next available price and aim to get the order filled swiftly. Stop-limit orders aim to control the sale price but may not execute if the limit price is not available.
What is stop-loss raiding?
Stop-loss raiding refers to the practice of intentionally pushing the price of a security lower in order to trigger stop-loss orders and cause a flood of sell orders. This is done by traders with the goal of acquiring shares at an artificially low price resulting from the increased selling pressure. Once stop-loss orders are triggered, the price can drop sharply as more shares are put on the market.
Traders aim to acquire shares at lower prices by coordinating sell orders and short sales timed with high sell order volume. This strategy works to artificially depress share prices temporarily. After stop-loss orders are triggered, the raiders will then buy back shares at the depressed price. When done on a large scale, stop-loss raiding can lead to flash crashes in a stock price.
How does stop-loss raiding work?
Stop-loss raiding is executed by traders in the following way:
- Identify securities with many stop-loss orders clustered around certain price levels. This information may be deduced from trading patterns and volume.
- Take large short positions in the identified securities. The short sales increase downward pressure on the stock price.
- Place large market sell orders timed to coincide with high market order volume from stop-losses triggering. This pushes the security’s price through support levels.
- Cover short positions and buy shares at depressed prices after stop-losses are triggered. The traders aim to profit from the artificial dip they created.
By coordinating intentional short-selling and high sell-order volume, stop-loss raiders can temporarily depress prices, trigger stop-losses, and then profit from the resulting price swing. Advanced algorithms may be deployed to identify potentials securities and automate order execution.
What are some examples of stop-loss raiding on Wall Street?
Some alleged examples of stop-loss raiding include:
- The May 6, 2010 Flash Crash – Stocks like Proctor & Gamble fell 36% temporarily, partially attributed to stop-loss raiding algorithms.
- Mini Flash Crashes in Apple stock – Suspected stop-loss hunting brought down the stock for 1-2 seconds on multiple occasions.
- Gold market volatility in 2013 – Stops were allegedly flushed in the gold futures market, depressing prices.
- Treasury Market Flash Rally in 2014 – A major flash rally in Treasuries was linked to hunting for stop-losses in the futures market.
While hard evidence of intentional stop-loss raiding is rare, regulators widely believe the practice contributes to short-term volatility and flash events across equities, futures, and currencies. High-frequency trading algorithms are often suspected culprits in systematic stop-loss raiding.
Why is stop-loss raiding illegal?
Stop-loss raiding is illegal as it constitutes manipulation of securities prices through coordinated trading activity. Intentionally pushing prices down to trigger stop-losses violates laws against securities manipulation and fraudulent trading practices.
In the United States, stop-loss raiding would violate Section 9(a)(2) of the Securities Exchange Act which prohibits manipulation of security prices. The Commodity Futures Trading Commission (CFTC) also considers triggering stops intentionally as illegal manipulation. Additionally, the practice violates SEC anti-fraud provisions when misrepresenting trading intentions.
Beyond being illegal, stop-loss raiding undermines market integrity. It causes unjustified volatility and deprives investors of fair prices. Markets function based on natural supply and demand, not artificial distortions. Regulators like the SEC take the threat of stop-loss raiding seriously and will prosecute perpetrators.
What are some techniques investors can use to defend against stop-loss raiding?
While difficult to prevent entirely, investors can take certain precautions to reduce the likelihood of being victimized by stop-loss raiding:
- Use stop-limit orders instead of stop-market orders – Stop-limits may execute at better prices than the raiders are targeting.
- Set stops further from current prices and use wider stop increments – This makes raiding more expensive and less profitable.
- Avoid stops on low-float, thinly traded stocks – These are easier to manipulate with less volume required.
- Be aware of support and resistance levels where stops may cluster – Consider avoiding placing stops exactly at common technical levels.
- Use defensive stop orders that adjust to market conditions – Trailing stops and volatility-based stops react to price swings.
While not foolproof, being aware of the risk and employing protective stop-loss strategies can reduce excessive risks. As always, diversification across many uncorrelated securities also protects against losses in individual positions that may occur during events like flash crashes.
Conclusion
Stop-loss raiding is the prohibited practice of intentionally pushing security prices down to trigger clustered stop-loss orders. By creating cascading sell-order flow, raiders aim to profit by acquiring shares at the resulting depressed price. Examples have occurred during flash crashes across equities and futures markets. Stop-loss raiding harms market integrity and contravenes laws against manipulation. Investors should be aware of the practice and design defensive stop-loss strategies. While difficult to prevent completely, prudent stop placement and advanced order types can reduce excessive risks. Markets fundamentally depend on bona fide supply and demand between investors, not artificially engineered price swings.