Spread betting: Don't give up on stop loss orders

By Deputy Editor Tim Bennett May 17, 2010

Tim Bennett

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Investors hoping to use stop losses to ride volatility "received a blow" recently as markets tumbled unexpectedly, says Alice Ross in the FT.

The trouble was not that stop losses didn't work, but that many worked too well.

As the market plunged on 6 May – the Dow Jones crashed 9% in a matter of minutes - stop losses were triggered, cancelling many open trades. "Fine", you might think. But that left many investors on the sidelines as markets subsequently rallied.

But stop losses are still a vital tool when it comes to avoiding losses that could cost you your shirt. Don't be put off by one freaky trading day.

The plain vanilla variety – also the cheapest – will ensure that if you hold, say, stocks at £3 and the price drops below £2.80 (your stop loss price), your position is automatically closed. But it suffers a major drawback called "gapping". That's where lots of orders are triggered together as the market drops and a broker executes them in strict price/time rotation. If yours is at the back of the queue, you may be closed out below your stop loss price.

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Solutions include choosing an uneven price – say £2.81 instead of £2.80 -  that bumps you up the list. Or you could choose the guaranteed stop:  these are pricier – perhaps costing 1% of the value of a trade – but they do what they say, and get you out at the price you specify.

Another neat variation on the theme is the trailing stop. This is where you choose a stop loss limit of, say, 25% (meaning it is triggered by a 25% price drop). If you then see your shares rise in value, the stop loss moves up too. That way you protect some of your cumulative gains in a bull market, whereas with a conventional stop loss you would only be closed out at your original price.

And whilst the events of that Thursday in New York may have been traumatic for anyone stopped out prematurely, as John Cotter at Barclays Stockbrokers puts it: "I've been spiked out when I didn't want to be. But am I glad I use them? Yes."

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Published in Spread betting explained | More articles by Tim Bennett

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