(Bloomberg News) When RJ Parsons put stop-loss orders on his 5,000 shares of MannKind Corp., he thought it would protect him from losing a chunk of his investment.
"That was about a $12,000 mistake for me," the 59-year- old retired military officer from Malibu, Calif., said in a telephone interview last week. MannKind dropped 38% within minutes on Jan. 19, five hours before the biotechnology company failed to win approval for a diabetes treatment.
Stop losses are orders to sell when a stock's value drops to a specified price. Many U.S. investors like Parsons use them to protect gains if they go on vacation for a few days, for example, or don't monitor their holdings regularly, said Randy Frederick, director of trading and derivatives for San Francisco-based Charles Schwab Corp. with 8 million brokerage accounts. They often don't understand how dangerous it may be to rely on them, said Frederick.
That's because stop losses may be executed before a stock rebounds when there's abnormal trading. The shares also might be sold at the next available price, which may be far lower than expected, said Frederick, who's based in Austin, Texas. They're especially dangerous when a stock closes at one price and opens lower the next trading day due to news that breaks overnight or during a weekend, Frederick said.
Market volatility over the past two years such as the decline on May 6 that briefly erased $862 billion in value from the equity market in about 20 minutes is even more of a reason not to use stop losses, said David Donabedian, chief investment officer for Atlantic Trust Private Wealth Management in Baltimore.
"A staggering total of more than $2 billion in individual investor stop loss orders is estimated to have been triggered during the half hour between 2:30 and 3 p.m. on May 6," U.S. Securities and Exchange Commission Chairman Mary Schapiro said in a Sept. 7 speech in New York. "The broad market indexes dropped more than 5% in five minutes, only to rebound almost entirely in the next 90 seconds," Schapiro said.
In Parsons's case, he had a stop-loss order at $7 on 2,000 of his MannKind shares, which he bought at $8.50 through his online brokerage account with Boston-based Fidelity Investments, he said. When MannKind, based in Valencia, Calif., fell to as low as $6.05 at 10:36 a.m. New York time from $9.37 within a minute, Parsons's position was sold. The stock bounced back to about $9 by 11:57 a.m. when Nasdaq OMX Group Inc. halted trading through the 4 p.m. close of U.S. exchanges that day because of "news pending," according to data sent to Bloomberg.
"Poof, it was gone," said Parsons, who said he's a real estate investor and entrepreneur. "I've been to Vegas with some fast company but this was pretty fast."