How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way

July 29th, 2007

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Recently, in How to take advantage of an impending crash- Part 4: asymmetric payoff, we mentioned that we will slowly reveal how to implement an asymmetric payoff strategy to take advantage of an impending crash.

Today, we will begin a series on this topic. For today’s installment, we will introduce a common tool used by traders, which is inappropriate for implementing an asymmetric payoff strategy- the contingent stop loss order.

Just what is a contingent stop loss order?

Traditionally, a contingent stop loss order is a sell order that will sent to the market the moment the stock price hit at or below a pre-defined level. For example, if you bought a stock at $1 and set the contingent stop loss order’s level at $0.90, then if the stock fell to or below $0.90, then a sell order for your stock will be sent to the market to be liquidated.  Conversely, in the case of short selling, the stop loss order gets activated when the stock price hit at or above a pre-defined level (say, $1.10 in this given example).

In theory, you can sell (or buy in the case of short-selling) the stock just at the pre-defined stop-loss price level. In other words, in the given example, your loss is pre-defined at $0.10, while your profit potential is unlimited. Therefore, in theory, this is an implementation of an asymmetric payoff strategy.

However, this implementation will not work in practice, especially in the event of a stock market crash. This is because stock price can ?gap? in the real world. So, what is the concept of ?gap?? Using the above-mentioned example, let’s say you bought the stock at $1.00 and by the end of the week, the stock price fell to $0.95. So far, your contingent stop loss has not yet been activated even though you are sitting on an unrealised loss of $0.05. Let’s say, on the Monday of the following week, catastrophic news hit the company of the stock. Thus, the first traded price of the stock on that Monday is $0.20. Your stop loss order gets activated, which by the time reaches the market, means that you can only get to sell the stock at $0.19. The outcome is that your lose $0.81 on the trade, instead of the theoretical maximum loss of $0.10! This concept works the same way in the case of short-selling whereby the stock ?gap? up instead of down.

Examples of factors that can cause stock prices to ?gap? includes:

  1. Behaviour of overseas stock market in a different time zone.
  2. Black Swan events e.g. September 11
  3. Takeover announcements

Therefore, of all the implementation of asymmetric payoff strategies, this is the least that we preferred.