When stops are triggered on the CME Globex and ICE systems, they do not become market orders. For US futures electronic markets, Stop Orders are really “Stop with Protection Orders.” The only time a stop becomes a market order these days is if the stop is being worked in the Pit.
When traders first hear this, the immediate question is, “Why do stop orders on electronic exchanges become limit orders?” Not only is that a great question, but the answers also explain the reasoning of why exchanges have found this the best way to execute stops.
There is no doubt that electronic trading has been a great benefit for traders and the markets. In many ways, trading on an electronic platform is preferable to trading in the pit due to greater transparency, speed of execution, and real time price analysis. However, if there is one drawback about electronic trading, it is that during time of high uncertainty and volatility, very short term vacuums can exist in the markets during which times very little bids and asks are in the market. These very temporary vacuums can be even worse in the overnight sessions.
Imagine a situation where you are long Corn from $4.50 and during the middle of the night something happens half way across the world to make the markets temporarily crashes. Let just say some European bank fails, the Euro crashes, the US Dollar explodes higher, and it causes Corn to gap down 25 cents immediately to $4.25. A few minutes after the Bank Failure announcement, the markets come back to their senses, the markets that sold off come back, the markets that rallied, come back, and Corn is now down only 10 cents instead of 25, and is trading at $4.40.
Now let’s assume you had a stop at $4.45, which is 5 cents below where the market was trading right before the announcement of the European bank failure. If that stop order instantly became a market order, you could have been filled at your stop level or any price between the stop and the low during the flash crash. In a situation like we just described, it would be possible to be filled at $4.25 on a $4.45 stop! This can potentially happen because the market was thin in the overnight session, the bids were pulled from the market but a lot of stops were triggered, and that kind of quick and violent selling pressure could have sent the market much further down than it deserved to be.
The exchanges recognize this type of situation is a real risk to traders so they implemented the “Stop with Protection” rules. Again, let’s say Corn was trading at $4.50 and you had your stop at $4.45. According to CME rules, when that $4.45 sell stop is triggered, it really becomes a sell limit 5 cents below the market. In this case a $4.45 sell stop becomes a $4.40 sell limit. During normal market conditions, maybe 99% of the time you get filled at your stop price or a tick or two away because most of the time the markets are acting efficiently. The problem is when the markets are not efficient and in a panic or a flash crash. In the case of the European Bank failure, your $4.45 stop would have become a limit order to sell at $4.40 or better. Because the market gaps down immediately to $4.25, you are not out of the market. The stop has been “jumped” and a limit order is waiting to be filled at $4.40. After a few minutes of the European Bank Failure announcement, the markets come back, Corn comes back to $4.40, and your $4.45 stop is filled at $4.40.
You may read more about “Stop with Protection” on page 12 of the CME Globex Reference Guide.
Another common question traders have is “how do I know how far away the “limit” will be from my “stop” price?” That is another great question and I’m glad you asked! The CME designated “Protection Points” for every market. For Corn it is 5 cents. That means if you have a buy stop at $4.50, the buy stop becomes a buy limit at $4.55. A sell stop at $4.50 becomes a sell limit at $4.45. Find the “Protection Points” for any product traded with the CME Group. For the ICE exchange, their equivalent of “Protection Points” is called “No Cancellation Range” or NCR.
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Turner’s Take was created to give traders and investors a window into the elusive world of LaSalle and Wall Street. My experiences at the NYSE, Goldman Sachs, NYU Stern and Daniels Trading have produced invaluable knowledge and contacts in our most vital capital markets. This wealth of experience and insight has proven to be a critical educational and investment vehicle for my clients and subscribers.
Risk Disclosure
STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENDING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE. IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A "LIMIT MOVE", IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.
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