Last month the New York Stock Exchange (NYSE) announced that it would no longer accept stop-loss and good 'till cancelled (GTC) orders. It went on to say that it would cancel existing orders of those types in its books, too.
The policy, subject to U.S. Securities and Exchange Commission (SEC) rule filings, goes into effect on Feb. 16, 2016, so there's plenty of time to prepare. Besides, GTC orders usually expire in 90 days, anyway. And of course the brokerages will continue to offer these types of orders. They'll simply trigger in-house and then be sent as limit or market orders for execution.
So, on the surface, this announcement doesn't seem like such a big deal.
But it is a very big deal. Partly for its effect on investors - though I'm going to show you how to get around it - but even more so for what the NYSE and its regulator, the SEC, are telegraphing with this decision: That they're essentially washing their hands of what's about to happen...
The Exchange Didn't Have Much to Say
The NYSE didn't offer much in the way of an explanation for its big change. Its only real response to the rule change came from an unnamed spokeswoman who wrote:
"Many retail investors use stop orders as a potential method of protection, but don't fully understand the risk profile associated with the order type. We expect our elimination of stop orders will help raise awareness around the potential risks during volatile trading."
Nevermind that investors have used these two order types as critical tools to limit their losses for over 100 years...
Nevermind that little distractions like life, careers, and family make it tough for regular investors to stay glued to their Bloomberg terminals 24/7. The NYSE suddenly thinks it's important for investors to smarten up about volatility.
Don't believe it for a second.
What's really happening is that the SEC is finally giving up on even trying to control trading on the exchanges it regulates. It's passing responsibility for investor losses along to brokerage houses and, ultimately, to individual investors themselves.
And it's doing it because the public face of trading, the venerable New York Stock Exchange, the stock market as we know it, is broken.
Here's How We Got Here
The United States has 14 stock exchanges and dozens of "dark pools." And because competing trading venues need orders to create transactions, they "pay for order flow" from brokerage houses and institutional money managers. All that competition spreads orders far and wide, so there's no singular exchange or place where hundreds or thousands of "standing" orders reside, waiting to be executed.
By not properly managing competing trading venues and allowing unrestrained selling of order flow, the SEC aided and abetted the "thinning of liquidity."
What's more, the minimum increment a stock can be traded in has also changed.
Up until 2001, stocks mostly traded in increments of an eighth of a dollar, or $0.125. Now, under decimalization, stocks trade in increments as small as a penny.
What seemed like a good idea to reduce transaction costs and narrow spreads - the difference between the price someone is willing to pay for a stock and the price someone is willing to sell that stock for (which used to be $0.125 and can now be $0.01) - turned out to be another nail in the market's coffin.
While decimalization theoretically reduced spreads and transaction costs, in practice what happened is investors didn't leave their orders standing around because intermediaries (meaning specialists on the NYSE and Nasdaq market-makers) could take a small one-penny-per-share risk and buy stock a penny ahead of a standing order they saw residing on their books.
By not correcting the mistake of decimalization, the SEC allowed short-term traders to front-run standing orders and use those standing orders as a backstop to exit their trades if prices go the wrong way. That unfair treatment caused investors to leave fewer standing orders in the market, which again aided and abetted the fatal thinning of liquidity.
Of course, the NYSE can't say any of that. All it can say is it won't accept stop orders.
It should say it's because market liquidity is so thin on big down days that stop orders will get filled way below where they should.
And the NYSE and the SEC would rather you blame your brokerage house for that - or blame yourself for a lack of "awareness around the potential risks during volatile trading."
So that's the bad news. The good news is you don't have to lie down for this...
The Easiest Way to Protect Your Money from the Rule Change
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It's important to understand what a stop-loss is and why it's so important to regular investors.
Stop-loss orders are mostly used by investors who, for a variety of reasons, aren't able or willing to watch the market all the time. By putting down a stop order, an investor could "stop the loss" on a position if the price of his stock fell to a predetermined level.
A stop order becomes a "market" order when the stop-loss price is reached.
For example, if you own a stock at $50 and want to sell it by using a stop order if it falls to $45 (for a 10% loss), once the stock trades $45, your stop-loss order becomes a "market" order and your stock is sold at the next best price someone is willing to pay. You may sell stock at $45, or less, depending on where other buyers are bidding for your stock.
There used to be lots of "standing" orders left with NYSE specialists and Nasdaq market-makers, so when a stop order was triggered, the seller could usually sell his stock at or just below where his stop order became a market order.
When there were lots of standing orders waiting to buy and sell shares, individual stocks and the broader market just didn't have the huge swings like they have today.
Buy orders could always get cancelled and a stock, or the market, could fall steeply. But buyers and sellers typically lined up to transact at prices considered fair and orderly.
That's all changed.
My advice is to keep using your stop-loss orders as long as your brokerage lets you because using them is smart.
Every empirical study ever done on using stop-loss orders and trailing stops demonstrates they can be incorporated in portfolio management to meaningfully enhance returns.
But be aware: Because of what the SEC allows to happen on their watch, you will get bad fills on your stop orders. That means you may get stopped out only to watch your stock pop right back to some higher level after you've been screwed out of your position.
If you choose not to use stop orders, you need to watch the market and your stocks. Like a hawk. It's always smart to keep tabs on what's happening with your money, but you'll need to be really vigilant because the SEC and the NYSE have abrogated that responsibility. Fortunately, you can easily stay on top of things by setting up alerts on your smartphone or computer to let you know when your positions hit a predetermined price.
And if you keep losing money because the market becomes increasingly volatile, or you're on the sidelines not making any money because you're afraid of what's become of the stock market, send a letter to the SEC and tell them to fire themselves.
They really deserve it.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.