Investors Pay Big for Loss Protection

There is one issue that we believe undermines the fabric and credibility of the stock market and it will darken everyone’s door some day. That issue is the murkiness of pre & after-hour trading and their impact on risk control tools like stop loss orders. Currently, these extra hours of trading do not trigger stop-loss orders. As a result, this creates an uneven playing field for those with the access and those without the access to pre/post market trading.  The impact of an uneven playing field in after-hours will ultimately be the undoing of the market in general.

However, before going into specific details, it needs to be said that standing stop-loss orders are very simple. An investor wishing to avoid significant loss can instruct their broker to automatically place a market order to sell their stock when the stock falls to a specified price (the opposite applies to short sellers). As the stock hits the indicated level on the way down (on the way up for short sellers), the stock automatically becomes a market order and is sold at the best available price. Normally, this procedure is done automatically once the shareholder provides these instructions to their broker.

While the process seems pretty simple, any investor who thinks that having stop-loss orders is a rational way to limit losses (or protect profits) are paying through the nose for the most recent lesson from Mr. Market. 

The latest lesson is with Verifone Systems (PAY).  After the market closed on February 20, 2013, Verifone announced that it would miss Q1 and Q2 targets (found here). At the close of trading on February 20, 2013, PAY was at $31.89.  Unfortunately, in after-hours trading, PAY declined -32.55% on trading volume of 4,783,086 shares.

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Then, in pre-market trading volume of 2,263,950 shares, PAY fell an additional -5% to the opening price of $19.97, a total decline of -37.28% from the close of market on February 20th to the open on February 21st.

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A total of 7,047,036 shares were traded in the combined post/pre-market trading resulting in the decline of PAY to the tune of –37.28%. During the regular hours of trading, the total volume of shares traded was 50,411,282 as the stock closed the day at $18.24.

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What needs to be understood is that roughly 12% of the shares traded caused PAY to decline –37% while 88% of the shares traded caused PAY to decline only –8%.  This is the equivalent of an 11-story building weighing more than the 102-story Empire State Building.

According to the NYSE Euronext website (found here):

“NYSE and NYSE Amex are the only equities markets that offer a rich combination of cutting edge, ultrafast technology with the volatility buffer of human judgment and accountability to create orderly opens and closes, lower volatility, deeper liquidity and improved prices.”

These are bold claims for NYSE Euronext to make when 12% of trades are allowed to increase volatility, decrease liquidity and destroy prices.  It is probable that NYSE Euronext will say that it doesn’t happen enough to warrant any changes.  However, investors will discount the after-hours by piling their trades into this narrow window between conventional hours of trading.  This is setting the markets up for the opposite of what the NYSE Euronext and other exchange operators claim to provide market participants.

Questions That Need Answers

  • Is it necessary to have the minority of traders affect the majority of the movement in the stock price while stop loss orders aren’t allowed?
  • If an investor has a sitting stop-loss order at a “reasonable” level, like $30 or lower, does it make sense that their shares automatically sell at the February 21st opening price of $19.97? 
  • Can the investor be given the option, when the stock falls more than -10% in pre/post trading, as to whether they wish to commit to their initial order during “regular” hours?
  • Should we get rid of pre/post trading hours?
  • Is the current system adequate?

We believe that market regulators need to answer these questions before the situation really, really gets out of control.   For now it only affects individual holders of the wrong stocks at the wrong time, which seems to be a little too frequently, of late.  At some point, there will be a mass of pre/post market participants that will cause a stampede for the narrowest exits on a much broader scale that will put into the question whether what remains of the current system actually works.

Until the time comes when the above questions are answered and changes are implemented, the next stock market crash will be born in the pre/after-hour markets with flash crash characteristics if this issue isn’t addressed. We recommend that investors avoid using stop-loss orders as a means of protection against downside risk or seriously consider making use of pre/after-hour market trading platforms.

8 Responses to Investors Pay Big for Loss Protection

  1. NLO Subscriber

    Excellent point and questions. The SEC will get right on this for us…

  2. Hail NLO:

    This is one time I do not agree with your wisdom….The stock had enough volume to justify the decline…
    Furthermore, the news was extremely bad and had the sell off been over played the stock would have recovered…

    Needless to say, no matter what one’s position status was losses where in order…Had the information been released during trading hours, a stop-loss may have mitigated the damage…Stop loss orders are the end all, so we do not always employ them…

    I am not sure about the trading after hours effect on the market in general…Is the next thing 24 hour trading, however?

    Could you imagine playing another season right after the finish of the Sir Lord Stanley Cup?

    http://blogs.barrons.com/techtraderdaily/2013/02/20/verifone-plunges-23-warns-fyq1-q2-to-miss-by-a-mile/?mod=SmartMoney

    RIP – Martin Zueig

    • Greetings and Welcome BlueIce.

      Let’s put this article and the recent decline in context.

      The last time that Verifone’s stock price was cut in half overnight was when the company had to restate their earnings (found here: http://www.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&newsId=20071203005476&newsLang=en). A less rosy picture for earnings doesn’t seem on par with a restatement of earnings.

      As indicated in our article title “A Comprehensive View On Valuing Earnings” (found here: http://www.newlowobserver.com/2010/05/a-comprehensive-view-on-valuing-earnings) Thomas Au rightfully says, “As far as I’m concerned, earnings are gravy or maybe it is the desert, assets and dividends are the dinner.”

      And while the volume was sufficient for the decline, 87% of the decline was on only 12% of the entire amount of trading that occurred, which took place at a time when all of the rules, of what is considered a “fair” market, didn’t apply. It’s like handing the money over to the guys who were on the other side of the transaction.

      Hey, if we went to 24-hours of trading then I’m all for it. However, I want all the same rules to apply. Otherwise, I would be against 24hour trading.

      Thanks for the comments BlueIce.

  3. Toue, thank you for your reply. I just experienced what you wrote about last night..

    We own RNDY, and I believed it closed 2.28.13 at 5.75. The stock was down to 5.50 because of overnight trading and open 3.1.13 at 5.55. The last I check, it was up .35 to 5.90! I suspect a lot of owners were stop out only to see the stock in the green.

    This can certainly make one see red! Where are the red-light cameras?

    • Greetings BlueIce,

      Sadly, this is occurring more and more in otherwise liquid stocks. While there is a clear record of these transactions taking place in after-hours without the ability for stop orders to be in play; there has to be an end-game somewhere.

      Unfortunately, the end-game is a crash in pre/after-hour markets on a broader scale before the issue is taken seriously.

      Best regards.

  4. I would be a very rich man if I had never employed stop loss orders. Therefore, I never use them anymore.