Protecting onself from steep losses with a stop-limit sell order

Question

I would like to get some feedback if there are any obvious flaws with this strategy of limiting my losses when there's a steep drop in stock price due to negative report after hours.

Suppose I own 100 shares of company XYZ currently trading at $200. The company is expected to report earnings after hours and I expect the earnings report to either be extremely positive or extremely negative. If the company reports positive results, the stock will rise by 10-15%. If the company reports negative results, the stock price will drop by 10-15%.

In an attempt to protect myself from a steep drop in stock price (and cash in if the price rises) I submit a stop-limit order at $185 - $192. If the company reports good results and the stock price rises after hours I earn 10-15%. If the company reports bad results and the stock plummets 15% to $170 I limit my losses at around $190 (5% loss instead of 15%).

I realize that this is a hypothetical example and I'm making several assumptions in this question including the fact that there is equal probability for the company to report good or bad results. But the main question is - is there anything that I might be overlooking that would prevent this strategy from working?

A few things I can think of off hand:

1) If the company reports bad earnings and the stock drops by 15% it might do so instantaneously (not slowly) so it is unlikely my stop limit order will ever get executed (Any truth to this?)

2) When a company reports bad earnings and I look at the chart the following morning it seems the price does fluctuate considerably after hours before it finally 'settles' at the 15% loss. Obviously, to take advantage of the high price point my order would need to be executed after hours. If my stop-limit order was submitted during regular market hours, would it be executed after hours?

3) Someone else could submit a similar stop limit order before I do and their order will execute before mine does as detailed in this response. Assuming there is limited demand at $185 - $192 my order may never get filled (obviously, the earlier I submit my order the more likely it will be that I will reduce my losses)

Anything else I missed?

Thanks!

Answer 1

In #1, you ask if there's any truth to the possibility of a gap preventing a fill.

Yesterday, IRBT closed at $89.63 and reported earnings shortly thereafter.

At 4:01:04, price was huge at $85.00 x $89.62 (always reminding me of Black Monday in 1987). The first problem is that the wide spread effectively runs all stops from $89.62 down to $85. OUCH. For all you know, the bottom could have been being put in around $89.50 or so, just be a recovery. But you're out for as low as $85. The lesson? Stop orders are dangerous in after hours as well as for pending news.

Let's suppose that are the unluckiest stop-limit picker ever. You put in a stop limit at $84.75 / $82.75. At $85 bid, you're still good. Not even 1 second later, price is $82.11 x $85.18 and IRBT has barreled through your stop and your stop limit prices. Sorry, it's "No soup for you!" Costanza. And with no subsequent price rise above $82.75, you're on the road to a low of $69.75 today with trading now at $73.30 .

It took 7 seconds and 34,000 shares (a nothing burger for this stock yesterday during AH trading) to drop the bid to $75.00 so even a limit as low as $75.01 might not have been filled if enough people were ahead or you on the order book (34,000 shares).

Yes, there's truth to this and it happens frequently when there are gaps.

There is merit to having approval for after hours trading. You can take profits and limit losses, assuming that the B/A spreads are not Holland Tunnel wide as above. It's also effective for locking in gains on options if you're lucky enough to be on the right side of the move.

An extreme example of this was election eve in 2016. Dow futures were down about a 1,000 points circa 11-12 PM and if you owned puts, you had a nice payoff coming the next day. By the time regular hours trading opened in the morning, the loss was gone and most likely, the options were a loser (IV contraction). So if you were short the market (SPY, IWM, etc.) or long the puts, you could have locked in some/all of the gains by trading during after hours. Otherwise, nada.

Answer 2

1) is the key flaw in this is in many asset situations prices jump from x to y with little to no trading in between (and can actually reverse the asymmetry you think you are exploiting on the upside, with losses far in excess of your expected upside).

Think of an asset like a house worth 200k on land worth 200k for a total value of 400k. Say you put in a stop at 300k to sell it any time it hits that value. You come home one day to see the house has burned down and weirdly your stop never got executed because all the market bids went from around 400k to just the land value of 200k as soon as the fire started.

So it is with companies, who can easily report entire collapses in a division/fraud/products being banned etc which cause all the liquid players to instantly drop prices by huge % amounts in the blink of an eye.

Answer 3

One real risk you run selling after hours as alluded to in the other answers is that volatility and price movement may not reflect the true direction of the stock after the announcement. This can happen even if there is no gapping and can happen during normal after the next day after an announcement as well, although that is probably less common now than it used to be in the past.

To make it perfectly clear - there is a risk that the company reports lower than expected earnings, the stock tanks, and your stop gets triggered, but then the stock recovers because the actual "greater than expected" loss was (for instance) already factored into the price of the stock by the actual participants in the market as opposed to analysts or well published predictions. I have also seen this happen on good news - the stock mysteriously starts dropping for whatever reason (sellers apparently convinced that results weren't as good as they were expecting, or profit taking, or whatever) and then a few hours later recovers as selling pressure is exhausted and more buyers come into the market pushing it above the previous close.