Friday, May 14, 2010

Vital Lessons Learned from the Market's Recent Freefall

Now "fat finger" and "high frequency" trades are part of the common vernacular.  Not much solace for those who lost money during the stomach churning drop.  What you must know to protect yourself from losing money, while the slow process of figuring out what happened occurs.
When you buy or sell stock, there are several ways that your order can be placed.  The first, and most common, is a "market" order.  When you place an order "at the market," you buy at the lowest price any seller asks, or sell at the lowest price any buyer bids. 
During the recent market free fall, however, prices fell precipitously.  Had you sold Proctor & Gamble "at the market" late in the day on May 6, you may have thought you were selling at about $61 per share, but were executed at $40.  That's because the selling was so intense and buyers were so few.  People in this predicament may have thought they were selling at a profit, but actually locked in serious losses.
So, lesson one is never sell "at the market."  Always enter a "limit" order" by checking the quote on the stock you want to sell, and entering it at the "bid" price.  That way, you'll be assured that your sale will be at that price (or better).
Some investors like to place "sell stop" orders.  These are orders that will automatically sell if the price falls to a given price.  Again, using the example of Proctor & Gamble, any such sell order for under $60 may have been executed at as low as $40, because the price of the stock fell so quickly.  Those who thought they were protecting their profits at $58 may have locked in losses at $40.
There are two lessons to be learned here.  If the investor absolutely wanted to place a "sell stop" order, if it is placed with a "limit" price of $58, the orders would have tried to execute when the price fell to $58, but if that price were not available because the price was falling so quickly, the order would not have been executed.  That investor would have likely been executed when the stock price bounced back later in the day.
Even still, after the execution when the price was on the way up, the investor would have sold at $58, and seen the price rise to $60 almost immediately.
The other alternative is not to place automatic orders at all.
This type of order was undoubtedly a part of the problem on May 6.  Why?  When many such orders are placed, more and more are executed as prices fall, causing more selling.  When there are few buyers, these type of orders just exacerbate the problem.
So, we never place a market order when selling stock.  We always place limit orders at the bid price.
We never place a "sell stop" order, without adding a "limit" price.  Perhaps we just don't place "sell stop" orders at all.
That's how we protect ourselves from unintended losses.  But there were some people who made money during the market drop.  What did they do?
Some were value investors.  These are investors who calculate the price at which they will buy a stock, and simply wait (sometimes for years) for the price they want.
Again, using the example of Proctor and Gamble, if an investor decided they wanted to buy this stock, but at a price no higher that $43 per share, she may have placed a buy order at that price that was "good until canceled."  That investor may well have had that order executed on May 6.
One of the problems the market experienced is lack of uniformity.  Stocks that trade on the New York Stock Exchange have strict rules during market corrections.  Trading is suspended for a period of time.  We take a breath.  We look at information.  We make informed decisions that are not based in panic.
Unfortunately, there are automated exchanges that do not have such rules, and trades will sometimes be routed from the NYSE to these other exchanges during a panic sell.
There is virtually no argument against implementing uniform trading suspensions in all exchanges.  The problem is executing this uniformity.  The programming that is necessary to ensure that all exchanges operating under the same rules is complex, and cannot be written in a day.  It will take time, but it's a good idea and will undoubtedly be a reality before the end of the year.
Until then, remember:
1)  Sell only with limit orders;
2)  If you place sell stop orders, add a limit price;
3)  Consider not using sell stop orders at all; and
4)  If you're patient, place buy orders at the value that the earnings stream is worth.
If you want to know how to calculate the value of future earnings, buy Mary Buffett's book titled "Buffettology."  Or make sure your broker does.

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