Why do dealers target stops?
I’ve been asked again, ‘why do dealers target stops?’.
Lets look at an example of an interbank dealer who is looking at his order book and sees stop-loss orders to buy 200 million EUR/USD at rates above 1.2900 up to 1.2910. The current rate is 1.2850 say. He has some options:
Option 1. He does nothing. He waits until the market breaks above 1.2900 and only then does he begin buying. The obvious problem in taking this course of action is that other dealers have similar orders and the market gets fast above the level. The customers who placed the stops will face excessive slippage and they will not be happy, plus the dealer doesn’t earn anything. All up a bad result.
Option 2. He buys smalls at 1.2850. The market starts edging higher so he buys another 20 or 30 (if the market goes down he cuts the position for a small-ish loss but the art of the dealer is being able to read the market and sense the weak side). He may sell some out on rallies as he averages his positions, but he keeps himself 20 or 30 long. Lets say his average entry rate for the 30 long is at 1.2870. When the market breaks above 1.2890, he buys more and then he buys large amounts at 1.2900 to ensure that the market trades at a rate above 1.2900, thereby ensuring that the stop-loss order is to be filled. Then he buys the balance of the orders. He will have bought 200 EUR/USD at an average rate of 1.2891 say. He will fill the stop-loss buy orders on average at 1.2903, with each customer being filled at close to their stipulated stop-loss level. The dealer will have ensured that the customers cannot complain about slippage and at the same time he’ll have earned $240,000+.
All dealers worth their salt will follow ‘Option 2’ which actually means that all stops are targeted.
There is sometimes a downside risk in that the dealer may buy large amounts but the market suddenly stalls at 1.2900 due to a barrier or a big Sovereign or corporate seller and they cannot get through to actually trigger the stop. If this happens the dealer must act very quickly to start exiting his position before the market turns lower. So there is some risk to the dealer. There have even been cases where customers left huge stop-loss buy orders above the market, but they were in fact trying to sell! They leave a huge stop-loss order with one bank, this bank starts buying aggressively, the customer then sells into the rally through a third bank and then cancels the stop-loss order, leaving Bank 1 high and dry. (Are you feeling sorry for the banks yet?).