Stop Loss Mechanism
Posted:Trading with leverage can be extremely risky. A share price move of more than 33.33% intraday would make a 3x leveraged investment in that share worthless (33.33% x 3 = 100%).
To reduce the risk of such a possibility, the indices that the Leveraged ETP Securities track incorporate a stop-loss mechanism.
When is the stop loss activated?
The stop loss is activated when the index level drops by 50%.
| Leveraged Factor | Index move | Underlying move |
|---|---|---|
| +2x | -50% | -25.00% |
| -2x | -50% | +25.00% |
| +3x | -50% | -16.67% |
| -3x | -50% | +16.67% |
How does the stop loss work?
Once an index stop loss event is triggered, the index is suspended, and an observation period starts. During that period, the lowest observed value (for long exposures) and highest observed value (for short exposures) will be recorded by the index sponsor. The observed value will be the new reference point until the end of the day or the next stop loss event on the day.
| Open | Stop loss event | Reference price | |
|---|---|---|---|
| Underlying | $100 | $83.33 | $80 |
| Index level in pts * | 10,000 | 5,000
[=10,000*(1+3*(83.33/100-1)] |
4,000
[=10,000*(1+3*(80/100-1)] |
* Before other adjustments
What happens after the stop loss event?
After the observation period ends, it is like a new trading day. The index performance will depend on how much the underlying rises or falls from the reference price.
Example 1 –Underlying goes down after the stop loss event
| Open | Reference price | Close | Day’s performance | |
|---|---|---|---|---|
| Underlying | $100 | $80 | $70 | -30%
[=$70 / $100 - 1 ] |
| Index level in pts * | 10,000 | 4,000 | 2,500
[=4,000*(1+3*(70/80-1)] |
-75%
[=2,500 / 10,000 - 1 ] |
*Before other adjustments
In the example above, over the day, the underlying asset fell by 30%. A 3 times long exposure without a stop loss mechanism would have suffered a 90% loss. However, because of the stop loss, the index is only down by 75% because of the reduced exposure to the underlying after the stop loss event.
Example 2 – Underlying goes up after the stop loss
| Open | Reference price | Close | Day’s performance | |
|---|---|---|---|---|
| Underlying | $100 | $80 | $100 | 0-%
[=$70 / $100 - 1 ] |
| Index level in pts * | 10,000 | 4,000 | 7,000 [=4,000*(1+3*(100/80-1)] | -30%
[=7,000 / 10,000 - 1 ] |
*Before other adjustments
Over the day, the underlying asset is flat. A pure 3 times long exposure would have finished flat as well. The index is down 30% because the stop loss reduced the exposure to the underlying after the stop loss event.
Is the stop loss always efficient?
As shown in both examples above, the stop loss results in lowering the exposure to the underlying asset. In Example 1 where the underlying asset continued to drop, the activation of the stop loss resulted in reducing the total loss relative to a leveraged exposure with no stop loss mechanism. In Example 2 where the underlying recovered to its original value, the activation of the stop loss, because of the reduced exposure, resulted in an overall loss on the day, which would not have been the case for a leveraged exposure without a stop loss mechanism.
Can the stop loss always prevent an investment losing all its value?
There may be situations where the underlying asset moves so quickly during the observation period that the resulting reference price implies a negative index value. However, the index level cannot be negative so it would cease to operate at zero. In such circumstances, the ETP Security referencing the index would be worthless and terminated. There would be no margin calls and investors would not lose more than their investment stake.
| Open | Stop loss event | Reference price | |
|---|---|---|---|
| Underlying | $100 | $83.33 | $60 |
| Index level in pts * | 10,000 | 5,000
[=10,000*(1+3*(83.33/100-1)] |
0
[=10,000*(1+3*(60/100-1)] |
* Before other adjustments
Based on the reference price, the index level should be negative. However, its lowest possible level is zero. The Leveraged ETP Security finishes worthless and is terminated. Investors lose the value of their investment but will not face margin calls.
Special cases: exposures on non-European stocks
GraniteShares Leveraged ETP Securities trade during European trading hours, generally between 8:00 and 16:30 UK time. However, some GraniteShares Leveraged ETP Securities track indices priced off Asian or US stocks. As a result, it is possible for a stop loss on such exposures to be triggered outside of European trading hours.
Is GraniteShares involved with the stop loss mechanism?
GraniteShares Leveraged ETP Securities track indices. The index stop loss mechanism is the responsibility of the index sponsor, which, once the stop loss has been triggered, establishes the reference price based on index rules.
