Time to Rethink Your Investment Strategy?

The recent stock market “flash crash” was unlike anything investors ever witnessed. In a matter of mere minutes, the Dow Jones Industrial Average plunged 990 points. Stop-loss orders – a market strategy designed to stem the bleeding – only contributed to the bloodshed on this particular afternoon. As investors lick their wounds, one question remains: Is it time to rethink your investment strategy? For insights as well as information about new stock market protections, read on.

POST FLASH CRASH: STEPS TO CONSIDER

The stock market may have recovered in the hours following the “flash crash,” but many investors are still in shock over the deep losses their portfolios suffered when the stop loss order so infamously failed. The Securities and Exchange Commission (SEC) is not only investigating the May 6 debacle, but working on instituting safeguards to prevent a repeat incident. However, in the end, the onus is on the investor.

Here’s a brief look at some of the strategies available to help you mitigate risk and protect your profits.

Stop Loss

In the aftermath of the flurry of stop loss orders executed during the flash crash, many investors came face to face with the painful reminder that investing in the stock market offers no guarantees. A tool that was designed to protect investors by limiting loss potential had failed.

In a perfect world, a stop loss order limits a stock’s downside by automatically selling shares that fall to a preset low. For example, you own shares of ACME Inc., which currently sell for $25 each. You are unwilling to hang on to the stock if the price falls more than 10 percent, so you place a stop loss order to sell at 90 percent, or $22.50. Assuming the order is triggered, it becomes a market order, and the stock is sold.

So what went wrong that fateful day? In an atmosphere of pure panic, stock prices plummeted so quickly that stop loss trade orders couldn’t keep up, forcing many investors to watch helplessly from the sidelines as their shares were sold at far below their trigger price. To add insult to injury, those same investors looked on as the very stocks that had been liquidated far below their stop loss order tolerance not only rebounded – but posted gains – at the market’s close.

The obvious advantage of a stock loss order – barring a catastrophic event – is that you limit the loss potential. You can be at the beach or in a meeting and, if the price of one of your stocks falls below your preset limit, a trade order will automatically be generated. There is generally no fee to place a stop loss order, and no cost unless a sale occurs, at which time you will pay any commission (plus tax on the sale, of course). So up until the flash crash, this investment tool was generally viewed as a win-win.

The risks:

As investors quickly learned, a stop loss order is not a guarantee that you’ll get your preset price. If the stock market experiences a sudden drop – like the May 6 flash crash – the stock’s price may slide right past the stop loss point, and sell for the best price available, possibly as low as a penny per share. (See right-hand box.)

Suppose the price plummets and your shares are sold, but you act quickly and repurchase. If you buy “substantially identical” shares within 30 days, the purchase may be subject to the wash-sale rules, which means you generally cannot claim the capital loss from the original sale.

If a market tumble causes an unexpected sale of shares that you have owned for less than a year, you could find yourself paying federal short-term capital gains tax of up to 35 percent on the sale, instead of long-term capital gains tax of 15 percent or less.

Stop Limit

You might be able to avoid an accidental sale of your stocks at a ridiculously low price by purchasing a stop limit order. This is a tool that requires the stock be sold at a specified price or not at all. There is a cost for stop limit orders, and they require a willing buyer, but the protection can prevent the problems associated with the stop loss.

The risks: With a stop limit order, the risk is that the price could drop below your designated sell-point and not rebound, leaving you stuck with the shares. Even so, this is a widely used tool. One brokerage director reports that while only 10 percent of his firm’s clients use stop loss orders, more than 50 percent use stop limit orders.

Portfolio Alert

A portfolio alert allows an investor to automatically receive notification, typically by text message, cell phone or email, should a stock’s price fall below a preset level – without a trade attached.

The risks: If the stock price drops below your low-end threshold while you’re away from your email or out of cell phone range, it could continue its free fall, without any safeguards. In the interim, you could sustain significant losses.

Short Sale

The “buy high and sell low” philosophy of a short sale bucks traditional wisdom. This is a tool you’d use if you expect the price of a stock will soon drop. Here’s how it works: You borrow shares from your broker, sell them, and later replace them at a lower price. The difference is your profit.

For example, you borrow 10 shares of ACME Corp and sell them for $50 per share. As you predicted, the price drops and you replace your broker’s shares at $40 each. Your profit is the difference, which is $100 ($50 minus $40 equals $10 per share, times 10 shares).

The risk: You could be wrong about the price dropping and will still have to replace your broker’s shares, but at a higher than expected price.

Put option

A put option is the right – with an expiration date – to sell a block of shares at a predetermined price. This is similar to buying insurance for a premium. The higher the stock’s volatility, the higher the premium. You are essentially betting that the stock price is going to fall, and protecting your investments from loss.

The risks: If your hunch turns out to be wrong and the stock price rises, there is no obligation to exercise your put option. Though you won’t be able to recoup the premium you paid, you can still profit from the higher stock price.

Buy and Hold

Buy and hold investors typically put their money on a company’s long-term growth potential, based on an in-depth study of the business’s past performance, current management and future outlook. Amid the investors running away from the stock market during the recent economic downturn and flash crash, these are the investors who are running toward it.

They’re looking to pick up shares of companies that have been beaten up in the short term – due, perhaps to the overall economy or an industry downturn rather than anything company-specific – at per-share prices that are akin to a rare garage-sale find. The result can be a handsome profit for these patient investors, who not only reap the rewards of a company’s growth down the road, but, when they sell, pay taxes at the more favorable long-term capital gains rate.

In addition, buy and hold isn’t typically a one-time deal. These investors often reinvest on a regular basis, reaping the benefits of dollar cost averaging. By investing a set amount on a regular basis, your money will automatically purchase more shares of a company or mutual fund when prices are down and fewer when prices are up. The end result will be that you’ll pay a lower average price. Good news: if you’re making regular contributions to your 401(K) plan, you’re already doing this – automatically.

The risks: In order to allow for short-term market fluctuations, buy and hold typically requires a minimum five-year time horizon. If you’re going to need to liquidate your investments in fewer than five years for retirement, to finance a college education, or even in the event of an emergency, you may not be able to reap all of the benefits this strategy has to offer.

These strategies, along with diversifying your portfolio, can help mitigate risk. During the month of May, the Dow, the S&P and the Nasdaq each fell approximately 8 percent. However, it’s important to remember that although there are no guarantees, a review of the history books proves that, over the long run, the stock market has historically outperformed other investments. As risk tolerance and timeline varies with each individual investor, it’s important to consult your financial adviser to help determine the strategy that best suits your needs.

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THE FLASH CRASH

On May 6, 2010, at 2:42 p.m. Eastern, the bottom fell out of the stock market … fast. In five minutes, 990 points vanished from the Dow Jones Industrial Average – long considered the barometer of the overall stock market – as Wall Street held its breath.

Ninety seconds later, the Dow reclaimed 543 points. At closing, the DJIA was still down 347.8 points, or 3.2 percent. Although it hadn’t managed a total recovery, it was a far cry from the 9.1 percent dip posted in early afternoon trading.

In the meantime, a lot of unhappy investors learned the hard way that stop loss orders can backfire. As the market tumbled, stop loss orders began to kick in automatically, causing stocks to sell for the best price available – not necessarily the price that investors had indicated. In some cases, that price was just pennies per share.

How did this happen? An investigation turned up many theories and no real answers. One is that a major trader was using an algorithm, which had a rogue effect on prices. Algorithms are meant to limit a trader’s influence on total market volume to a certain percentage.

Here are some details reported about the flash crash:

3.5 million shares sold for less than 10 percent of their value, in 11,510 trades.

Shares that were valued at $212.4 million just prior to the flash crash sold for $557,516 minutes later. For some small stocks, the prices shot up, more than doubling, then fell.

Nearly 200 stocks briefly lost almost all their value, selling for one penny.

More than 70 percent of the penny-trades involved short-sellers.

Brokers’ computers were overwhelmed, making it impossible for many desperate traders to make contact.

The computer chaos, combined with the use of multiple trading platforms, resulted in some pricing inaccuracies.

Is there any way to prevent another flash crash? There are some new electronic protections already in place.

Currently, circuit breakers cause trading to halt for one hour across all U.S. markets if the Dow falls by 10 percent before 2 p.m. Eastern, or for thirty minutes if a drop occurs between 2 p.m. and 2:30 p.m. After 2:30, there is no halt unless the market drops 20 percent, in which case trading ends for the day.

After the May 6 debacle, the SEC announced that circuit breakers will halt trading if stock prices move 10 percent – up or down – in a five-minute period. The SEC stated that the exchanges and FINRA would begin implementing the newly-adopted rules on June 11.

The five-minute pause for stocks in the S&P 500 Index, according to an SEC press release, “would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion.

A pilot period will remain in place through December 10, 2010, according to an SEC press release, to allow the markets “to make appropriate adjustments to the parameters or operation of the circuit breakers as warranted based on their experience, and to expand the scope to securities beyond the S&P 500 (including ETFs) as soon as practicable.”

In a statement, SEC Chairman Mary Schapiro said the circuit breakers would “increase market transparency, bolster investor protection, and bring uniformity to decisions regarding trading halts in individual securities.”

BUSINESS WISDOM FOR TODAY’S ECONOMY

They say history repeats itself, and the stock market is no exception.

Get some historical perspective on the ups and downs of Wall Street »