The other day one of my option positions really took off, giving me some really nice gains. I placed a trailing stop on those positions to ensure I wouldn't lose those gains. When I checked those positions at the end of the day, I found that I had been stopped out. I checked the price graph for the underlying stock and found that it had increased (without any downside spikes) all day long. It appears to me that the market maker artificially lowered the "bid" price just to take me out. When I checked CBOE, I noted that my trade was the only one that day. So, if no one else was selling, how could my trailing stop get hit? I'm wondering what material benefit the market maker received by reducing my gain? (December 30, 2004)
The market maker received a substantial material benefit. He bought at an artificially low price and most likely unloaded it right afterwards or a day or so later. This is a major problem with stop losses, particularly with options, simply because it is very hard to monitor.
In theory your stop order is not supposed to trigger until there is a trade at that level (or lower if a stop loss order which is a market order). In other words your stop should not be triggered unless an option trades at your stop price or lower (if a stop limit, generally it would have to trade at your price). That can cut both ways; we have had a stop in that was not triggered when we wanted it to be triggered simply because no options traded until a lower price. We learned the hard way that a stop loss will work against you when you think you are being safe and putting in such an order. It can also work against you just as you outlined: you think you are being safe and preserving gain in the event of a problem arising. Instead the price is manipulated lower, you are taken out, and then the price rises again.
Both have happened to us. We have been the victim of a market maker running a price down and taking out a position where we were utilizing trailing stops. It has been blatant at times as buying remained strong, but the price was dropped and immediately moved back up in an instant after we were taken out. Other times it has been more of a result of the ebb and flow of the market, but that certainly wasn't the case with your options.
It is not only options. We have lost good stock positions on NASDAQ stocks where just after the stop is put in the price runs right down and takes us out only to move right back up. It is frustrating to think you are doing the smart thing only to get stopped out. You preserved the gain, but you wanted to use it if there was a real problem. When there is a real problem, however, the stop loss usually does not help you either. If bad news comes out and your stock gaps lower, you are taken out at a much lower level than you wanted; then the stock rebounds some in a relief bounce and you get the worst trade of the day. What a great feeling.
With very liquid stocks and options this is not really a problem. Only when fewer options are traded do you really get burned. Thus we mainly keep mental stop points using alerts or otherwise to keep us abreast of the moves and then decide if we want to sell out (enter a sell order) or let the position ride. It is very important to realize that stop losses are nowhere near the safety net they are made out to be or believed to be by many.
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