There are a number of topics that come up on a regular basis among traders, 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 engage in 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 orders. [Note: when referring to stop orders going forward I’m referencing a standard, plain vanilla stop order, opposed to a stop limit order.]
1. Triggering stops without a trade – For example, XYZ is currently trading at $20.50, and you have a stop 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 trade price 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 your stop, or trigger price, is hit. Once it is, your market order is then live, and acts like any other market order.
But what you might not know is that there does not have to be an actual 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 order, which can then be filled at wherever price the market is trading at.
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, when 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 the same price. Stop limit orders at the same price as a stop order will get priority, and will be filled first, even if they were placed after the stop order. In fact, stop limit orders below the price of stop market order can still get priority over a stop order.
The “philosophy” behind this exchange rule is that by placing a stop 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 order, turning it into a market order, then continues to $19.98 before filling that market 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 (formerly stop) order, limit orders at $19.96 will get priority over it as well.
As you can see, in a fast market, especially in thin stocks, your stop order can trigger, drop significantly and remain open, while stop limit orders are getting filled in front of it.
3. Midday stop hunting – Often, during the middle of the day, you’ll see stocks dip and run stops, usually below obvious support levels, only to reverse immediately and begin climbing. This occurs because there is a tendency for liquidity to dry up during the middle of the day, which means less volume is needed in order to move a stock.
I hear complaints all the time from people who 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. Sometimes 50% or more of as stock’s total daily volume takes place during these time periods. That leaves 5.5 hours of relatively light volume, where price can more easily be manipulated 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, so for them, the more the better. And in each of the three scenarios above, the framework is designed to create as much volume as possible.
If price can’t trade low enough to trigger a transaction, just throw a quote out, trigger the stops, and unlock the volume.
What a tragedy it would be if falling prices bypassed limit orders, failing to trigger a trade? So why not facilitate the best opportunity to create transactions by prioritizing limit orders over market (formerly stop) orders, which don’t have to be filled at a specific price?
And low volume periods during the day allow easier price manipulation and the ability to “clear out” areas where stops congregate.
UPDATE: Reader’s comments below:
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:
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.
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.
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.
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….