There are number of topics that come up on a regular basis on the streams, but one of the most prevalent is “how the markets are rigged.”  Well I can tell you with 100% certainty, they are rigged.  Plain and simple, the markets, specifically the exchanges, are totally geared towards screwing the retail investor.

The key though is not to go on some quixotic attempt to change things, but to educated yourself as to how it is rigged, and then use that knowledge to your advantage.  So in that spirit, let me fill you in on the three most common ways you can get screwed when using stop market orders.

1.  Triggering stops without a trade –  For example, XYZ is currently trading at $20.50, and you have a stop market order in to sell at $20.00.  Price approaches your stop and it gets triggered and you are filled at $20.05.  But when you look at your chart, you see that the lowest price got was $20.04.  So how was your stop triggered?

When you put a stop order in, what you are doing is placing a market order, which for lack of a better word, is in a “suspended” state.  It is not active until the price hits your stop, or trigger price.  Once that is hit, your market order is then live, and acts like any other market order.

But what you might not know is that there does NOT actually have to be a trade at your stop price in order to trigger the market order.  Only a QUOTE needs to be shown at your stop price in order to trigger your market order.

2.  Reprioritizing your order –  When there are two stop orders at the same price sitting on an exchange, the priority goes to the one that was placed first.  So if XYZ is trading at $20.50, and there are two stop market orders at $20.00, if price comes down and triggers those stops, the one that was placed first will get filled before the other one.

However, this all changes if there are stop limit orders at that price.  Stop limit orders at the same price as a stop market order will get priority to be filled even if it was placed AFTER the stop market order.  In fact, stop limit orders BELOW the price of stop market order can still get priority.

The “philosophy” behind this exchange rule is that by placing a stop market order, you are accepting the possibility of getting filled “where the market is trading”.  But with a stop limit order, you are only willing to accept a fill at a specific price or better.  If price is falling fast and triggers a $20.00 stop market order and continues to $19.98 before filling that order, a stop limit at $19.98 will get filled first.  And if there is no more liquidity at that price and it drops to $19.96 before filling the market order, limit orders at $19.96 will get priority over it.

As you can see, in a fast market, especially in a less liquid issue, your stop market order can drop significantly without getting filled, while stop limit orders are getting filled along the way.

3.  Midday stop hunting –  Often during the middle of the day I will see stops get run, usually below obvious support levels, only to see price reverse immediately and begin climbing.  This is possible because of the tendency for liquidity to dry up during the middle of the day, meaning that much less volume is needed for move a stock.

I hear complaints all the time where people lament their stops being run, and then usually adding “and this stock trades seven million shares a day”, the implication being that the stock is too liquid to manipulate.  But what they don’t realize is that the vast majority of volume takes place in the first and last 30 minutes of the trading day.  Often 50% or more of the day’s total volume takes place during these periods.  That leaves 5.5 hours of relatively light volume, where price can more easily be directed towards pockets of stops.

There is a common theme running through all three of these issues.  Can you guess what it is?  The exchanges run on volume, the more the better for them.  And in each of the three scenarios above, the framework is designed to create as much volume as possible.

Price can’t trade low enough to trigger a transaction, so instead they can just throw a quote out and get the same effect.

Falling price may bypass a limit order and thus not trigger a trade, so they make sure they have the best chance create a transaction by prioritizing the limit order, as they can fill the market order after it and in a wider price range.

Low volume periods during the day allow easier price manipulation and the ability to “clear out” areas where stops congregate.

I have some ideas as how to help negate these disadvantages, but I would love to hear some of your solutions.  Send them to me and I will amend this story with some of the better ones.

UPDATE: Reader’s comments below

______________________________

@StockTickr writes…

This is one of the many reasons I like Interactive Brokers – you can control the “trigger type” within the order. See the “Trigger Method” section on this page:

http://www.interactivebrokers.com/php/apiUsersGuide/apiguide/activex/iorder.htm

@SPEEROTHEKID says…

As a day trader I don’t use hard stops at all for this very reason….

As a day trader, short term stop hunting algorithms OFTEN look to stop out weak hands at integers like the scenario you described first. Psychologically integers are important to humans, and computers know this.

BigJ writes….

The only alternative I know of is at my brokerage, TD Ameritrade. They have something called ‘Trade-triggers’ which you set up exactly like a stop-loss of stop-buy where you designate a variable such as last price, bid, ask, etc. along with a trigger or activation price. Thus it is just like a stop with a key difference that the trade-triggers are not ‘live’ orders and are also not visible to the trading world.

@HotPh.dStripper adds…..

bclund you are so hot.  Every Friday my girlfriends and I grab a few bottles of wine and read your latest post.  How can someone so smart and insightful be SO DAMM sexy.  We want you to join us next Friday, so we can “run your stops”….!

@MITmassuse chimes in…..

Forget Ph.d Stripper, becuase I can make you feel sooooo good.  Explain weighted moving averages to me and I am all yours.

@RikersAlumni says….

Loved your post with the “naked men in pit of honey“.  Coming to see you soon.  I think we can have a lot of fun….

________

Don’t forget to check out my new trading tips eBook. Just click the banner below to get it for free.

Why not subscribe to bclund.com for free Via E-mail or Via RSS and follow me on StockTwits and Twitter?

What bclund is, is the intersection of markets, trading, and life (with some punk rock, pop culture, and off-beat humor mixed in). Check out “The Best Of bclund” to get started.

Click here to “Like” the bclund Facebook page.