All spread betters offer stop-losses, limit orders, trailing stops and take-profit orders to allow you to protect any profit you might have made, or reduce your losses should the market turn against you. But problems can arise when investors think their stop-loss has not kicked in. This is often due to confusion over what a stop-loss actually does.
You should be aware that a stop-loss is not a contract to close the position at a definite level, but an instruction to trade that is triggered by a pre-defined price. To trade, though, you need both a buyer and a seller. Imagine a share at 105p with a stop-loss set at 100p. Bad news could cut the share price to 97p at a stroke. The stop-loss is triggered and the trading software is prompted to sell at 100p - but to whom? With the market at 97p, no one will want to buy a share for 3p more than they need to.
Slippage
In practice, stop-losses work well in normal market conditions. The spread-betting companies that we spoke to said that the vast majority of their stop-losses are filled at the level specified by the client. E*Trade could even put a figure on it: 99.3 per cent.
But when the market is particularly volatile, you cannot expect a simple stop-loss instruction to protect you. The price will gap up and down without ever trading in the small, steady increments that would allow everyone's stop-losses to be filled. For example, if a big news event occurs overnight, the market is likely to open some distance away from where it closed.
But gapping can work in your favour, too, as Mic Mills, a senior trader at TradIndex, points out: "If you have a long position with a stock and there is a takeover bid, the price might gap upwards from 200p to 250p at a stroke. If you had set a 'take profit' limit order at 220p, you would be filled at the price traded - 250p - not at the limit order price. It works both ways."
Always make sure you know what price will trigger the stop-loss because it's not as obvious as you might think. Some spread betters use their quotes to decide when to trigger a stop-loss. Others allow you to specify what you want. At Cantor, clients can choose how a stop is hit.
"Whatever gives them the most peace of mind," is how Cantor's David Buik puts it. "They can choose from market bid, market offer, Cantor's bid or Cantor's offer. People are, on the whole, relaxed about using our prices but, if they are trading from market charts, it is understandable that they would prefer 'market bid' and 'offer' as their mark."
Just remember that, whatever price you use, some slippage is inevitable from time to time. Trading on the UK markets stops at 4.30pm - hours before the US closes. If price-moving news then emerges in the US, UK shares may open sharply higher or lower. It is a market risk against which no stop-loss can protect you completely.
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Guaranteed stop-losses
If you want more peace of mind, then consider a guaranteed stop-loss. This will close your position at the level you specify, come what may - if there's a terrorist attack or run on the pound, you know the maximum amount of money you could possibly lose.
There are still two snags with this type of stop-loss, though. First of all, they do not come cheap. Most spread betters will charge you for them by widening the spread for any position opened with one. For example, the spread on a FTSE 100 position would be two points wider from most spread betters, while the spread on a stock such as Barclays would be three to four points wider. That means Barclays' share price would have to move by 3p to 4p more in your direction before you would make a profit on the trade.
The other problem is that you do not have a free hand when deciding where to put your guaranteed stop-loss. "The spread-betting companies will not allow a guaranteed stop-loss closer than a long way away, which negates the whole point," argues Simon Denham, managing director of Capital Spreads, which does not offer them.
Depending on the stock and the spread-betting company, the closest you can get is between 5 and 10 per cent away. In other words, you would still lose up to 10 per cent of your initial investment before the guaranteed stop-loss kicked in.
The Financial Services Authority, which regulates spread betting in the UK, is even rumoured to have launched a discreet enquiry into guaranteed stop-losses because they are so profitable for the spread betters, who often hedge their guaranteed stop-loss exposure using deeply out-of-the-money put options that they can buy cheaply.
When deciding whether to use a guaranteed stop-loss, Dan Moczulski of IG Index recommends that you ask this question: could the market jump by more than the guaranteed stop-loss premium, and does that risk concern you? If you know your stocks well, you will have a feel for the likelihood of jumps of different sizes - for example, how often Barclays has fallen in 4p increments.
