Should skilled investors use stop-loss trading strategies or derivative instruments to protect a portfolio during periods of market turbulence? Do such protective strategies work? Are they costless?

During a period of downside turbulence capital markets are likely to become tightly coupled. Investment portfolios become more fragile because negative shocks to world markets propagate through capital markets more quickly and pervasively than during bull market periods. Tight coupling often means that assets with low or negative correlation during normal market conditions suddenly exhibit similar downside return patterns. This, of course, may reduce the effectiveness of portfolio diversification as a risk control strategy during severe market declines.

Although diversification — the inclusion of assets with return patterns that tend not to mimic each other — is the classic method of portfolio risk control, a variety of other risk mitigation techniques are available. Given the sequence of volatile equity market returns from the plunge in the technology-heavy NASDAQ stock exchange in 2000 through the global recession and the recent U.S. & European sovereign debt credit rating downgrades, investors wonder if trading or financial engineering techniques can mitigate declines in portfolio values.

Two protection strategies are commonly advocated by some stock traders and portfolio managers:

Stop-Loss Orders: As defined by Investopedia, a stop-loss order is “an order placed with a broker to buy or sell once the stock reaches a certain price.” It is “designed to limit an investor’s loss on a security position … Setting a stop-loss order for 10% below the price you paid for the stock will limit your loss to 10%. This strategy allows investors to determine their loss limit in advance, preventing emotional decision-making.” Advocates of stop-loss orders generally suggest that every buy order simultaneously include a stop-loss order.

It costs nothing to establish a stop-loss order. However, the Investopedia definition fails to discuss a potentially disastrous result. A stop-loss order commits the investor to make an offer to sell a security when its value has dropped by a certain percent. For example, a security purchased at a price level of $100 with an accompanying 10% stop-loss order means that if the price declines to $90 an “at the market” sell offer is automatically triggered. However, there is no guarantee that a counterparty buyer will want to take the trade at the offered price of $90. In fact, during a liquidity crisis, if lots of investors have standing stop-limit orders, the at-the-market price could drop far below $90 before a willing counterparty emerges to fill the order. There are many cases where investors, believing that standing stop-loss orders provided a protective floor for their portfolio, were shocked to discover that the orders were filled at price points close to the absolute bottom of a security’s price decline.

A classic example of such an onerous result is the “flash crash” of May 6, 2010 where, within the space of only a few moments [2:32 pm to 3:00 pm Eastern Standard Time], the Dow Jones Index fell 900 points only to subsequently recover most of its value. Amazingly, the stocks of eight companies in the S&P 500 fell to a price of $0.01 per share for a short period of time. Many market commentators believe that high-speed trading based on algorithmic formulae combined with downside stop orders — the execution of which put further demands to submit high-speed sell orders — resulted in a cascading price decline in which the large sell order volume simply overwhelmed the market’s ability to provide downside protection to many investors with standing stop-loss orders. The stop-loss orders transmogrified into catastrophic-loss orders.

Options: Unlike a stop-loss order, an option costs money. Options contracts provide their owners with the right, but not the obligation, to buy or sell a security at a contractually fixed price for a specified, but limited, period of time. For example, an investor holding a security currently valued at $100 might seek downside protection by purchasing an option to sell the security at any time during the next six months for a contractually set price of $90. Such an option is called a ‘put’ or ‘protective put’ option. By holding such a contract, the investor is assured that he can obtain a fixed price of $90 if he should elect to exercise the option. Unlike a stop-loss order, however, the put option does not automatically trigger an offer to sell at the market price. If the investor believes that the price decline is simply the result of a normal market consolidation and that it is likely to rebound, he is not forced to make an offer to sell.

Although an option’s contractual provisions are more favorable than those of a stop-loss order, nevertheless they are not always suitable for investors. When option contracts are in the same direction as market momentum, their cost can increase dramatically. When your house is not on fire, the property/casualty insurance premium is reasonably priced. If you wait until a fire starts before calling your insurance broker to obtain a quote for coverage, you may find that the insurance company is a bit reluctant to offer a policy at any price less than the full value of the home. The same is true for options. During normal market conditions, the investor pays a periodic price — an insurance premium, in effect — to renew the insurance coverage provided by his option contract. This outlay acts as a constant drain on portfolio performance — insurance is never free! And, they vary with the insurer’s perception of risk. When markets turn volatile, the price of put options can go through the roof. For example, during the multi-year plunge in the NASDAQ stock exchange, the price of three month put options on certain technology stocks rose to 20 percent or more of the total current value of the stock. In some cases, the downside volatility was so severe that investors had difficulty finding a counterparty to a put option contract at any price. Thus in order for his options to be an economical — or even effective — form of portfolio risk mitigation, an investor must maintain them in force at all times, being sure to “renew coverage” during periods of relative market calm, when premia are low. And this may not always be possible, for there is no telling when a new spate of extreme volatility will begin, so that there is no way to be sure it won’t coincide with expiry of an option contract.

The concept of portfolio risk mitigation through trading or financial engineering strategies is complicated. Derivative strategies employ a variety of contracts including swaps, options, futures, options on futures, etc. Commonly advocated strategies encourage investors to cede a portfolio’s upside (gain) potential to avoid downside (loss) potential. Such a device may employ a “costless collar” strategy, which is definitely not costless if an investor wishes to cede an equivalent amount of gain to protect against a loss during volatile market conditions. At this point, it is helpful to remember the basic principle of finance known as ‘the law of one price.’ This reminds investors that any two investments having identical cash flows and terminal payoffs must sell for the same price. If they did not, there exists an opportunity to make a riskless profit by selling the overpriced investment and buying the underpriced investment. Such opportunities are rare in competitive and liquid markets. Another expression of the law of one price is the well known phrase: “there’s no such thing as a free lunch” — if you avoid market risk you avoid market return. The investor attempting to lock in “costless” downside protection is probably better off with an appropriate allocation to short-term, default-free fixed income investments that do not require constant payment of renewal commissions to a derivatives broker. But this is simply a variation on the traditional theme of maintaining an asset allocation appropriate for long-term cash flow and wealth accumulation needs.

Insurance is neither riskless nor costless. After careful review and thoughtful deliberation, we at SCLC have decided that we should not employ stop-loss trading orders or financial engineering techniques under most circumstances. After prudent deliberation we have concluded that such strategies often do more harm than good.