When RJ Parsons put stop-loss orders on his 5,000 shares of MannKind Corp., he thought it would protect him from losing a chunk of his investment.
"That was about a $12,000 mistake for me," the retired military officer from Malibu, Calif., said in a telephone interview in late January. MannKind dropped 38% within minutes on Jan. 19, five hours before the biotechnology company failed to win approval for a diabetes treatment.
Stop losses are orders to sell when a stock's value drops to a specified price. Many U.S. investors like Parsons use them to protect gains if they go on vacation for a few days, for example, or don't monitor their holdings regularly, said Randy Frederick, director of trading and derivatives for Charles Schwab Corp. of San Francisco, which has 8 million brokerage accounts. They often don't understand how dangerous it may be to rely on them, Frederick said.
That's because stop losses may be executed before a stock rebounds when there's abnormal trading. The shares also might be sold at the next available price, which may be far lower than expected, said Frederick, who is based in Austin, Texas. They're especially dangerous when a stock closes at one price and opens lower the next trading day because of news that breaks overnight or during a weekend, Frederick said.
Market volatility over the past two years, such as the decline on May 6 that briefly erased $862 billion in value from the equity market in about 20 minutes, is even more of a reason not to use stop losses, said David Donabedian, the chief investment officer for Atlantic Trust Private Wealth Management in Baltimore.
"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 in New York. "The broad market indexes dropped more than 5% in five minutes, only to rebound almost entirely in the next 90 seconds," Schapiro said.
In Parsons' case, he 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 of Boston, he said. When MannKind, of Valencia, Calif., fell to as low as $6.05 at 10:36 a.m. New York time from $9.37 within a minute, Parsons' position was sold. The stock bounced back to about $9 by 11:57 a.m. when the Nasdaq halted trading through the 4 p.m. close that day because of "news pending," according to data sent to Bloomberg News.
"Poof, it was gone," said 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."
Parsons then placed another stop-loss order at $9 to protect gains on his remaining 3,000 shares, he said. MannKind announced around 3:30 p.m. on Jan. 19 that it 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, Parsons said his shares sold at $5.07, or $4 less than his specified price.
"They remove investment judgment from the equation," said Donabedian, who generally advises his clients against placing stop-loss orders on shares. Atlantic Trust, of Atlanta, has more than $16 billion of assets under management. Investors don't always get the price they want and may lock in a loss before a stock rebounds for a "double whammy," he said.
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 guarantee a price, but not an execution of the sale, he said. They may not provide greater protection than stop losses because if a stock falls below the limit before it's sold, investors may be stuck with the security, Murphy said.
Diversifying your portfolio is one way to mitigate risk without a stop loss or limit, said Pamela Rosenau, managing director and equity-market strategist for HighTower Advisors, which is based in Chicago. "You don't want to have oversized positions," in one stock, said Rosenau, whose office is in New York.
Investors may also use options to hedge risks against declines, said Frederick and Murphy. Options are contracts that grant buyers the right, without the obligation, to buy or sell a security at a set price. But unlike stop losses and limits, they cost money.
"It's like an insurance policy, so if you don't need it, you end up spending money on it anyways," because the option has an expiration, Frederick said.
Still, "let's say I owned a $9 put option and the stock drops to $6. I can call my broker and say I want to exercise the put option, in which case I'm able to force my stock on somebody else at $9 a share," Frederick said.
Schwab doesn't track the frequency or volume of stop-loss orders, said spokesman Neil Shapiro. Fidelity also couldn't provide data, said spokesman Stephen Austin.
Stop losses may work in markets that are slowly declining because orders may get filled relatively close to their trigger prices, Frederick said.
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," Parsons said of volatility in the stock market.
Nasdaq spokesman Wayne Lee declined to comment in an e-mail 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 5-minute period, said Ray Pellecchia, a spokesman for the New York Stock Exchange in a telephone interview.