Volatility underlines the dangers of stop-loss orders

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By:
Paul Golden
Published on:

FX buy-siders aren’t convinced of the risk-management potential of stop-loss orders, after many were disappointed with results following big swings in volatility last year.

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Risk management of any resting orders left at particular price levels depends on market participants’ ability to assess how and when that limit might be triggered.

An obvious concern during periods of heightened volatility associated with reduced liquidity is that limits might be unexpectedly triggered outside of what might be considered normal market behaviour.

“That tends to increase caution around placing stop-loss orders, which in itself might also mean that volatility can be exacerbated as there is no set of resting orders that might provide a natural floor to any price movements,” notes James Kemp, managing director of the Global Financial Markets Association’s global FX division.

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Henry Wilkes, IFXAP

According to Institutional FX Advisory Partners (IFXAP) founder Henry Wilkes, the use of FX stop-loss orders has dwindled since the decision of the Swiss National Bank in 2015 to stop intervening in the EUR/CHF market, when many banks stopped offering these orders to their clients because of inherent market and credit risk.

Celent analyst Brad Bailey goes further, suggesting that dealers and brokers would have actively cautioned clients against using stops.

“Events such as the EU referendum and US presidential election show the weakness of stops as a fully deterministic risk-management tool – prices might gap or move so rapidly that buy and sell orders are executed far away from intended prices.”

David Cooney, CEO of MahiFX, observes that the management of stop losses is becoming more deterministic as they are increasingly controlled by machines rather than people.

He accepts that market participants can see the downside of having no constraint on the level of risk they take and would appreciate certainty in how the order will be filled without it affecting price formation.

David Cooney
David Cooney, MahiFX

However, Cooney also points out that irrational demand from clients to get their orders filled without slippage in already volatile markets increases the pressure on dealers. 

“The only way for dealers to make money is to sell into the stop-loss, whereas a machine would not want its price formation process to know anything about its order book,” he says.

Celent’s Bailey agrees that stops can be improved with more advanced algos that react to conditions and can trail prices. One way to overcome the gapping with stops is to use stop-limit orders, which assure order fills in a certain price band. However, the risk then is that the stop might not be filled.

“Illiquid markets are often a recipe for disaster with poorly managed stops,” says Bailey. “Pockets of price illiquidity can cause ‘stopping out’ of traders on both the short and long side. These price discontinuities might fill a stop at a dramatically different price than someone was expecting.”

IFXAP’s Wilkes describes the mechanics of stop-loss orders and individual bank and broker policies as a grey area, since clients often assume that once they leave a stop-loss order they are covered from any market movement that might happen.

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Brad Bailey, Celent

Stops are held on by a trading desk, for the most part on servers, explains Bailey, who says he would not place a stop-loss order with a broker without a thorough understanding of their protocol for going to market on a stop and how they are held and managed.

According to Wilkes, the efficacy of stop-loss orders depends on the kind of stop-loss the client leaves, which bank they leave it with and the liquidity conditions in the market at the time.

“My sense is that they are less effective at minimizing losses following unexpected outcomes of known events – the result of the EU referendum being a good example – because the market becomes a completely one-way street with everyone rushing for the exit and very little liquidity available,” he says.

“Having said that, GBP/USD has never recovered, so if you had left a stop-loss at £1.4000 you would still be better off now – even with a bad fill – than if you had not left a stop-loss at all.”

It is quite possible there have been instances where banks and brokers used stop-loss orders to assist their own proprietary trading book to the detriment of the client, concludes Wilkes.

“They never used to publish policy and procedure documents, but with regulatory pressure for more transparency and looking after client’s best interests, this should now be a requirement,” he concludes.