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Why will the NYSE stop accepting stop orders?

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

The NYSE has become the latest exchange to announce plans to no longer accept stop orders and good-till-canceled orders, beginning Feb. 26.

NYSE joins the Nasdaq and BATS to announce such plans.

A stop order is an order to buy or sell a stock when it passes a certain price. It then becomes a market order, but it may or may not execute at exactly the stop price.

If the order is "good till canceled" it remains open until an investor cancels it or a trade is executed.

Say a stock is trading at $60. You put in a stop order at $55. If the stock hits $55, that order will become a market order and will sell at the market price, which hopefully is close to $55.

Why is the NYSE doing this? It issued the following statement Tuesday night: "Many retail investors use stop orders as a potential method of protection but don't fully understand the risk profile associated with the order type. We expect our elimination of stop orders will help raise awareness around the potential risks during volatile trading."

Here's the problem: When you get rare events like what happened on Aug. 24, when the Dow dropped 1,000 points within a few minutes of the open and then bounced back minutes later, it creates all sorts of stresses on the market system. Stocks trade down big and then recover.

So let's look at an investor who had a stop order that day. Let's take a stock that closed the previous day at $60. Our investor has a stop order at $55, meaning sell it if it hits $55. It opens at $54, so the stop order becomes a market order and it gets executed at $54.

Five minutes later, the stock is trading at $58. The investor is not very happy. The investor had a stop order in to protect against the stock dropping but didn't expect it would bounce back a few minutes later.

The investor is a victim of an extreme case of market volatility.

What could be done to protect against having that order execute in that type of market? Not much. That order executed properly. The investor could use a limit order, which would only execute at the limit price or higher. So if the investor put in a limit order at $55, it would only have sold at $55 or higher, rather than at $54. But that is small consolation.

Stop orders are not new. They are one of the oldest order types on Wall Street. One famous Wall Street pundit, Nicolas Darvas, wrote a now-famous book in 1960, "How I Made $2,000,000 in the Stock Market," where he outlines the extensive use of stop orders.

These orders are used exclusively by retail investors. Why? Because retail investors don't usually have the time to sit around and watch their stocks. A stop order provides some protection in the case of a notable drop.

Professionals don't use stop orders.They have the time to sit around and watch.

Some brokers will still take stop orders, they just won't be executed at the NYSE, or BATS or Nasdaq. It would likely be executed internally, or in a dark pool.

The long-term solution is for retail investors not to put in stop orders and to pay more attention to what they have and when they might want to sell what they have (or buy more of what they have).

And that's what the NYSE is trying to say.