When Stop-Losses Don’t Stop Your Losses

06/22/2011 1:47 pm EST

Focus: GLOBAL

John Heinzl

Reporter and Columnist, GlobeInvestor.com

As this example illustrates, stops don't always work as advertised…and the result of missing the right exit point can be painful, writes John Heinzl, reporter and columnist for Globe Investor.

I had a stop-loss order on 600 shares of Sino-Forest (Toronto: TRE) at $16.27, and the stop-loss order (which also had a limit of $16.27) was not triggered on Thursday, June 2, when the stock went from about $18 to $14. The next day, Sino-Forest plunged to about $5, but my shares weren't sold. Do you have any recourse to suggest to me to correct this costly situation?

Stop-loss orders can be an effective tool, but they don't always work as advertised—and investors must use them with caution. This is especially true in volatile markets.

Unfortunately, what appears to have happened in your case is that Sino-Forest's stock was falling so rapidly that, when the price hit $16.27 and your stop-loss order was converted to a limit order (also at $16.27), the broker was unable to sell at that price. The stock had already plunged through that level, so your order was not executed.

Let's back up for a moment and explain how stop-loss orders work.

With a straight stop-loss order, when the stock reaches a predetermined price, the order converts into a market order. This means your broker will sell the shares at the best available price.

The problem is, it could be well below the trigger price if there are no other bids on the books. (This is what happened to many exchange-traded funds during the "flash crash" in May, 2010.)

To avoid this, whether you're trading ETFs or stocks, it's important to include—as you did—a limit price with your stop-loss order. This specifies the minimum sale price you would accept.

However, if you place the limit too close to the stop price—in your case, the stop and limit prices were identical—you run the risk of not getting your order filled.

"In a volatile market, a stop-loss limit order may not be executed, in which case the investor will continue to be exposed to a declining stock price," the Investment Industry Regulatory Organization of Canada (IIROC) said in a recent bulletin.

Some brokers now insist that investors include limits with their stop-loss orders. BMO InvestorLine, for example, requires that investors set a stop limit that is no more than 20% below the stop price. But even when you use a limit, there are no guarantees.

"Before making a decision about what stop limit price you choose, it is important to understand that a high stop limit reduces your…order's ability to be executed, especially in a rapidly declining market," BMO InvestorLine says.

***

Recently my mother passed away and left me as executor for her estate. Her full-service adviser suggested that we should cash out her exchange traded funds "because record keeping and tax reporting are more difficult if funds are transferred."

I cashed one of my mother's US ETFs worth nearly $30,000—and now realize that the commission was $578 (about 2%) and the exchange conversion cost was $959 (about 3.2%).

I should have asked the advisor for the cost of selling these funds. However, shouldn't this information have been provided to me as executor?

Here's what IIROC said on the subject: "Generally, IIROC-regulated firms provide formal disclosure of fees and commissions at the time of account opening and 60 days in advance of any change to their fee schedule. They are not required to do so at the time of a transaction."

However, I got different answers from two investor advocates.

Ken Kivenko, president of Kenmar Associates, said the executor could complain to the firm about the lack of disclosure. "B,ut I doubt they will do anything," because the advisor did not strictly violate any policy, even though the recommendation to sell the ETF may have benefited the advisor at the expense of the estate.

The executor could also file a complaint with IIROC, or the Ombudsman for Banking Services and Investments (OBSI), or take the matter to small-claims court. However, given that the executor has a "weak" case, "I think the person should move on and save the aggravation," he said.

The problem is that under current laws, commission-based advisors do not have a fiduciary duty to act in the client's best interest. "When advisors have a fiduciary duty, this kind of abuse will be greatly reduced," Kivenko said.

On the other hand, investment dispute consultant Robert Goldin said the executor may have a case.

"There's no reason why an advisor should start trading in an account that is owned by a deceased's estate," he said. "It would appear that he was trying to make as much money as he could, having regard to the fact that he may not be around much longer to administer the portfolio once the estate is wound up."

"The civil law imposes a duty of care upon a person who is administering or doing something on behalf of someone else. The financial advisor has to understand that if he's making a recommendation, he would have to get feedback from the [executor], and the [executor] can only make an informed decision when they know the full pros and cons of a particular investment," including fees and commissions.

His advice is to take the matter to small-claims court.

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