Stock Market - Domino Effect of Stop Loss Orders
Many retail investors and speculators have the habit of putting stop loss order as soon as they open the positions. It is mostly true especially in futures and commodities market as well as forex trading. Since futures and forex trading do support leverage of upto 20 times in some cases. Meaning that if you have $ 5000 cash, then you can buy the contracts worth upto $ 100,000 (20X leverage).
Leverage often gives more profits however if the market direction is not favorable you may lose your entire money. Consider this scenario: As soon as a retail investor opens a position, he adds a stop loss order with 2% down from the current stock price. Similarly other retail investor and speculators keeps adding stop loss of between 1.5% - 3.0% down from current stock price.
That stock might be overcrowded due to recent good news and expectations. Based on technicals as well as fundamentals, the stock price will tend to move higher. Since it is overcrowded, some big investors or hedge fund manager may place a market order to sell short the stock that can take the stock price down by about 1.5-2.0%. As soon as it is down by 2%, it will start triggering stop loss orders of the amateur and novice investors by pushing the price down further down. As deep it does down, it has got the domino effect of triggering other peoples stop loss orders. Once the stock is down by about 3-4%, the hege fund manager will cover their position and take new long positions that can push the stock price up by 3-5%.
Poor amateur investors will keep beaten down by the market with this situation frequently. The best way to avoid this problem is, trading on your cash position with out any leverage. Instead of adding stop loss order, consider buying put options to hedge your positions.
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