Q&A: Why does the market gravitate toward stop-loss orders?

Author: Jamie Coleman | Category: News

It is not purely that traders want to stop-out customers in order to derive some perverse pleasure. A lot of it has to do with risk management.

Let’s suppose you have a large stop-loss order in EUR/USD and you are the spot trader at Snidely, Whiplash and Company.

The definition of a stop-loss is an order that becomes a market order once a certain price is dealt. So if you have an order to buy EUR 500 mln 2 pips above a key technical level, you need to be a buyer at a point when many others in the market are likely to be buyers as well.

What can you do?

Two things. You can wait for the market to deal at the price where the stop is set and then try and execute a large order at the next price, likely pushing the market against the customer. Customers hate sloppy fills on stops, so you may end up eating a loss…

Or you can begin buying once you get close to the stop in anticipation of the order being filled. As a dealer, you go long ahead of the buy-stop and fill the customer close to his order level. The customer is thankful that his stop was done at an attractive level and the dealers books a profit while limiting the risk that the market runs away from him.

But there is a downside. What if you buy ahead of the stop and it is never triggered. You have a position that you need to manage that very well could turn into a losing position.How often do we see markets get close to a level where there are lots of rumored stops only to reverse as dealers have to bailout of positions taken in anticipation of filling those orders having to liquidate? Pretty often.

Keep that in mind the next time you get ticked at your dealer for “running your stop”. Very often they’ve taken risks on your behalf that did not end up working out for them…