Safe Stock Trading

Investors know stock investing carries risk, and many will use trading strategies to mitigate it.

But not all risks can be so easily protected against, in particular those inherent to electronic trading.  Extremely high volumes of orders moving at the speed of light through a global network of interconnected exchanges at the command of automated algorithms and computerized trading programs create risks impossible to completely neutralize.

But regulators are telling everyone everywhere to simply relax.  Things aren’t as scary as they seem.

Crash Susceptibility

Possibly the best known and most referred to example of the risks associated with today’s huge scale of electronic trading is the “flash crash” of May 6, 2010, in which U.S. stock markets lost over $1 trillion worth of stock value in just five minutes.  Those losses were reversed within minutes, with untold trade executions declared null and void over the course of several days.

After a lengthy 5 month investigation, it was determined that a large mutual fund had sold an unusually large number of E-Mini S&P 500 futures contracts, which dried up pre-cued buy orders over a rather large price gap down.  This panicked high-frequency traders to sell too, further amplifying the downward spiral.

Buy orders are usually very congested close to the current market price, with fewer and fewer pre-cued buy orders at lower price levels.  Once you exhaust that nearby congestion of buy orders, the price can fall in leaps and bounds through all those thinly spaced buy orders further below.

To make matters worse, a number of automated trading programs will initiate “defence mechanisms” which cancel cued-up orders in the event of abnormal volatility.  This auto-cancellation of buy orders thinned out the buy side even more, creating larger gaps for the price to fall through.

What worries many is that the same conditions which exacerbated that cascading sell-off are even more widespread in today’s ever growing electronic trading universe.  In the most recent case of a known flash crash, shares of Anadarko Petroleum (NYSE: APC) plummeted from near $90 to just 1 penny in just the final minute of trade on May 17^th.  A slew of trades were later declared defunct.

Safety Measures at Work

Of course, there are some events that adversely move markets legitimately.  These can range from a worse than expected economic report to a news bulletin of a major financial decision – either real or potential.  Gold traders will not soon forget the April 2013 report of Cyprus’ then-impending gold sale, which pushed gold off its recent cliff.  Regardless of how unfounded that news flash turned out to be, it was a legitimate event, and the flash sell-off it triggered cannot be considered an error.

Sell-offs, then, are not preventable, neither the legitimate kind nor even the ones resulting from human or computer error.  All that can be done is to put in place safety measures designed to spot errant trading activity, halt it, record it, and then undo it as quickly as possible.

“Circuit breaker” programs that previously halted trading only on stock exchanges have since the 2010 flash crash been applied to individual stocks as well, and with great success.  The Financial Industry Regulatory Authority reports that incidents of “clearly erroneous” trades during the last 6 months of 2012 were down 84% from the first 6 months of 2009.

These circuit breakers halt trading for 5 minutes if a large-cap stock’s price dropped 10% in a 5 minute span.  Since this April, the U.S. Securities and Exchange Commission has incorporated additional limit up/limit down rules, which insert a 15-second pause when those up or down limits are reached, just in case prices reverse, thereby avoiding unnecessary 5 minute halts.

Another safety measure tracks erroneous trades by tracing them back to the brokerage responsible, triggering investigations into a firm’s order execution systems if errors are abnormally frequent.

And these safety mechanisms are continually being upgraded.  Where current rules deactivate the halting mechanism during the first 15 minutes and last 25 minutes of the trading day, new rules in just two months’ time will keep those halting procedures in play throughout the entire trading session.

Despite these safety measure, more can still be done to protect investors in the marketplace.  A number of market experts are calling for more transparency from FINRA, the SEC, and the exchanges, demanding that news of trading errors be published along with a summary of causes and steps taken to insure that any improprieties or negligence are being addressed.

Investor Precautions

Even with a wide number of safety mechanisms put in place by regulatory bodies and exchanges, perhaps the greatest safety measures are those undertaken by investors themselves.

Since we know that the vast majority of trading errors and irregularities occur in low volume, thinly traded stocks, investors can defend their positions in such instruments with safety measures of their own.

Put options can in some cases work quite well, although illiquid stocks will likely have illiquid options, which can force you to pay a high premium for protection against crashes that are really quite rare.

Stop-loss orders, though widely used, can actually cause more harm than good if used on a stock with low volume.  Stop-loss orders can trigger you out of a position at a very poor price on even a normal trading day.  And if you come home to find you were indeed stopped-out, you would in most cases have to buy back the next day at a higher price than you just sold at.  Stop-loss orders really work best in liquid markets.

The “no-brainer” precaution would be to simply avoid illiquid stocks all together.  With so many investment choices out there, one hardly needs the headaches associated with the potentially spastic movements of a low volume stock.  Trading a larger company in the same sector may be a viable alternative.

If you decide, however, that you simply cannot pass up the potential of a particular illiquid stock, always make certain there is enough cash in your account to cover any huge swings in that stock’s price.  In this way, any flash dive in that stock will not cause an automatic liquidation of all your other trades, which would happen if your account runs out of cash.

Remember, a stock’s price will be automatically corrected after an erroneous trade is discovered.  But any trades in your other positions that were triggered because of that suspect stock will not be un-done.

Joseph Cafariello

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