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A sure fire way to lose billions

Last week’s fake-tweet-inspired 150-point free fall and subsequent recovery in the US Dow Jones industrial average got a lot of attention from the investment world.

Many people focused on the vulnerability of social media sources like Twitter in disseminating news, while others looked back to the much larger plunge and recovery that investors experienced almost three years ago in the fabled 1,000-point Flash Crash. For the most part, investors have already started to shrug off the episode, given that it only lasted for a few minutes and that stocks regained all of their losses.

But even though it was short-lived, the mini-Flash Crash exposed a couple of mistakes that just about every investor has made. One of those mistakes caused immediate losses for investors. For the other mistake, investors won’t know the full extent of the damage it causes for a long time to come. Let’s take a closer look at these two mistakes.

1. Having automatic stop-losses

Many investors use stop-loss orders to try to limit their potential exposure to a decline in a company’s share price. A stop-loss order involves your choosing a price level for a given stock as your trigger point. The stop-loss price should be below the stock’s current price, and if the stock price drops to a level at or below your trigger point, your broker will automatically execute the order, selling your shares.

As a long-term move, stop-loss orders can save you from huge losses if a stock continues to decline. For instance, during the 2008 market meltdown, many investors who set fairly tight stop-loss orders based on the stock market’s 2007 record-high levels ended up selling their stocks well above their eventual lows in late 2008 and early 2009.

But last week’s episode shows the danger of stop-loss orders. Many traders had stop-losses that triggered during the market’s plunge, selling them out near the lows of the day. Just minutes later, the stocks returned to their previous levels, forcing traders who’d just had their positions ‘stopped out’ to replace them at higher prices.

During the US Flash Crash three years ago, many trades triggered by stop-loss orders ended up getting reversed. But because this incident was much less severe, investors shouldn’t expect the SEC to step in to reverse trades during the short period of market disruption.

2. Not being ready to buy

Even if you don’t have any stop-loss orders triggered in such an event, you may still make a mistake. If prices on stocks you were interested in dropped far enough that you would’ve wanted to buy them, then not having a plan in place to purchase them on the dip could well cost you.

Some stocks stayed in tight trading ranges except for those few minutes. Citigroup (NYSE: C) saw shares fluctuate more than 1% but barely budged the rest of the day. Similarly, Intel (Nasdaq: INTC) took the roller-coaster ride in its stride and finished near the levels where it traded before the incident. Neither stock had much company-specific news moving its shares, so the tweet-induced plunge was one of the big events of the day.

Foolish takeaway

Last week’s big swing wasn’t substantial enough to be a huge loss for anyone but the big institutional short-term traders that fell prey to the market’s fake-out. But it shows that the markets are still vulnerable to news-induced moves, and next time, the reaction might be a lot bigger.

Make sure you’re ready to take advantage of it if it happens here, and to avoid any big mistakes that could make you its victim. 

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More reading

The Motley Fool’s purpose is to help the world invest, better.  Click here  for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by Dan Caplinger, originally appeared on fool.com.

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