The market frenzy triggered by the Swiss National Bank’s (SNB) shock move on January 15 2015 to scrap its EUR/CHF floor underscored a brutal lesson for retail investors: stop-loss orders don’t always work.
Clients place stop-loss orders to manage their FX exposure by stipulating the precise details of the order such as price, amount and duration, quantifying the maximum loss on any FX position or strategy in the market.
However, when markets become highly illiquid due to unusual or unexpected events, the ability to get stop losses executed at the preferred rate is compromised.
Stop-loss orders are a common element of risk management in FX, both in terms of medium-term portfolio management and shorter-term trading.
However, on Black Thursday the best available price for stop-loss orders, in some cases, was a fraction hoped for by some retail clients on platforms, such as spread-betting poster-child IG, resulting in significant losses and slew of litigation proceedings.
The episode underscores the need for retail traders to get up to speed with dealing rules and procedures enacted by trading platforms that might challenge their ability to secure prices at stop-loss levels.
Since the Brexit vote on June 23 is seen as a big macro-event risk – resulting in huge swings in GBP, CHF and high-beta currencies depending on the result – trading volumes and FX rates are expected to see huge swings in volatility.
Stop-loss orders are complicated by inconsistencies between platforms, and inconsistencies between orders on the same platform, in the execution of the orders, says Paul Chappell, founder and chief investment officer at C-View.
“Usually a client has the choice of whether stop losses are executed automatically or handled manually with a degree of discretion afforded to the market maker, but some market makers are considerably more adept at managing stop losses than others,” he says.
Henry Wilkes, founder of Institutional FX Advisory Partners, explains that since banks tend to have their own stop-loss order policies, it is important for clients to understand the specifics of these policies.
“The main difference is how the price of the stop-loss order is achieved, which ranges from a guaranteed stop loss at the price stipulated by the client, to a certain number of pips or basis points away from the stipulated price or the next price available in the market if the stop loss is triggered,” he says.
“Some orders will trigger if the stop-loss price trades in the market, others only once the market price moves above or below the stop-loss price depending on whether it is a stop buy or stop sell.”
Nicholas Laser-Ebisch, corporate account manager at Caxton FX, notes that if there is no system in place to automatically book in the stop loss, it is possible the desired conversion will be booked in at a worse rate than originally instructed.
“Large financial institutions generally have systems in place which will book a stop loss within fractions of a second once the exchange rate hits a trigger level,” he says.
“However, with some smaller entities it is common for orders to be handled manually when smaller sums are involved.”
A clear agreement between counterparties as to whether discretion is or is not allowed in these circumstances is helpful, says James Kemp, managing director of the GFMA’s global FX division.
“The global code provides some guidance on specific considerations for market participants when placing stop-loss orders, which should increase uniformity of disclosures and transparency in key terms,” he says.
Paul Stafford, chief engineer at Synops, notes that a quick search will turn up copious guidance for traders on how close to the market to set stop-loss orders and how to manage them.
It is important to understand exactly the type of stop order your broker is utilizing, as well as the mechanics of how it is implemented, agrees Brad Bailey, research director at Celent. “For instance, certain stops will be triggered by a quote versus a trade.”
When asked whether market players are becoming more reluctant to take stop-loss orders from clients, Gary Wright, CEO at BISS Research, observes that regulators like to see stop loss practiced as it provides protection for investors.
“There should be no issue with any financial institution accepting stop-loss orders – if it did, I would ask serious questions and refer it to the regulator,” he says.
However, Wilkes at Institutional FX Advisory Partners points out that stop-loss orders can be an expensive service to offer and that clients can abuse the service by only leaving stop-loss orders and no other kind of order or FX business with their bank.
Fast-moving markets will make market players less willing to take orders or widen out their margins when taking orders to protect against any losses involved, adds Caxton’s Laser-Ebisch, while GFMA’s Kemp observes that market participants are sensitive to any potential conduct-risk issues and will naturally err on the side of caution when it comes to orders that require discretion or judgement to be exercised.
It is a case of caveat emptor after unusual or unexpected events, says Chappell, concluding: “Clients should only expect stop losses to be filled dependent upon market conditions, liquidity and spread of pricing.”