Guaranteed stop loss orders have increased in popularity in recent times as traders try to limit their risk against an unprecedented market volatility.
Here, we consider what a guaranteed stop loss order is, and how it can be useful in your trading.
To understand the need for a guaranteed stop loss, you have to realize that an ordinary stop loss order simply instructs the broker to close out your position when the market reaches a certain price. It’s normally used to protect you from runaway losses if the market goes the wrong way. The only problem is that the stop order becomes a market order to sell when the price hits the level you set, and although your broker pledges to do their best to sell at your preset level they are unable to guarantee the price. In fast moving markets, this could mean that the actual price you get may be at a worse price level from the level that you set. The amount you lose because of this is commonly referred to as slippage.
With a typical stop order you’re not guaranteed the price that you put it in at. Were the price to gap through it then you would be filled at the first available price after it has gone through. With a guaranteed stop, it doesn’t matter if it gaps or not – as long as the price has been met then the price you put your stop loss order is the price you will get. So if I had been long on BAE Systems at 2.44 and had my stop loss at 2.39, I would have been filled at 2.39.
To get around this, some brokers offer a guaranteed stop loss order, where you give the broker a price and if the CFD drops to that level the broker will liquidate your position and give you that price. A guaranteed stop loss (gsl) is simply a stop that caps your absolute worst-case scenario when trading CFDs. GSL’s are intended to reduce the volatility of your portfolio during turbulent times or if you are trading shares that are prone to market gaps. As the broker may not be able to actually sell at the price, the broker charges a premium for this service which covers him against losses. You can think of it like an insurance premium, where everyone pays a little to cover the occasional large loss. Guaranteed stops are commonly used when trading share CFDs on margin since share CFDs are particularly susceptible to slippage and gapping in the opening phase of the market.
Examples of a GSL Order
Let’s take the case of a scenario where you buy a CFD position at $20 just before the end of the trading session. Fearing some overnight volatility you link this trade to a GSL order. Assuming you place the GSL order 5% away from the $20 entry level you would be placing the GSL stop at $19. If there were some key developments overnight it is fairly common to see shares gapping down on the open If the $20 share happened to open at $18 the next morning, then in normal trading conditions you might be able to sell your position at $18 which implies that you would stand to lose $2 per share CFD. In our case with the guaranteed stop order in place, the CFD provider would stop us at $19 which means that we would save $1 per each share CFD.
Darren Moglia of Macquarie’s Head of Direct Investing gives another example. As the figure below demonstrates, on an investment in 10,000 XYZ at $20 per share, if an investor locked in their GSL at $19.80, their loss would be limited to $2,000. For an investor without a GSL, a share price fall from $20 to $18 would result in a $20,000 loss. For a premium, the investor using the GSL has saved $18,000.
Catches of using Guaranteed Stop Losses to Trade
While the idea sounds like a good one, much of the time you will find it is more expensive than using a regular stop loss, and settling for the price that the broker can get. Additionally, guaranteed stops are only available on certain indices and leading shares. They have an associated minimum stop level that may, for example, be no closer than 5% below the current share price.
There is an extra fee levied for guaranteed stop orders that is really akin to an insurance premium. This is charged when the transaction is opened and will either take the form of extra commission or, in the case of an index, a premium on the spread of maybe an extra three or four points. The margin requirement is also altered to reflect the amount that would be lost if the stop were triggered. Traders are left with the decision of whether the risk of an index or blue chip gapping past a normal stop justifies the extra cost. Note that guaranteed stop losses are usually charged for in advance, and if the price does not go against you but instead makes a profit, the money will be wasted.
Are Guaranteed Stops worth the extra Cost?
Stop losses are important; guaranteed stop losses are something to be considered carefully before spending the money as you have to pay an extra ‘insurance’ premium which could be anything from 2 to 4 times the normal brokerage cost. The types of situations where a guaranteed stop loss may be worthwhile include trading on securities that may be subject to mergers and takeovers which could change the price suddenly; trading CFDs in overseas markets that you think are risky; trading overnight in volatile conditions, where there might be a gap open in the morning; and any time you think that the price could make a sudden move.
For example, you might buy a contract for difference in the stock of company A, which is currently trading at £35.50 on the London Stock exchange. Company A is currently in court fighting a lawsuit for damages. If company A wins, then the shadow that has been hanging over it is lifted and it is likely to increase in value by 20% to 30%. If company A loses, however, the share price could fall 20% to 30% on the news.
Despite the cost of the premium, in this case you may consider it worthwhile to take out a guaranteed stop loss on your trade. You can limit the downside to, say, 10% with the guaranteed stop loss, and hope for a win in court so that you will make a large profit from your trade. If company A loses you need not panic at the sharp fall in value, as the broker has underwritten your loss to be no more than 10%. Note also that charges for the provision of guaranteed stops will vary from CFD broker to another and can be easily researched before you open an account.