The Role of Stop-Loss Orders in Market Efficiency and Stability: An Agent-Based Study

Abstract

Stop-loss orders can have large and ranging effects on the behaviours and outcomes for participants within financial markets. We develop and demonstrate an approach to studying the effect of stop-losses on price dynamics within a financial market. Using our high-fidelity agent-based market simulator that draws on historical limit order book data, we illustrate that the introduction of stop-loss orders leads to volatility, creating the potential for stop-loss cascades that result in large price movements. We study a market containing an agent that is able to trigger such events and profit from them. We indicate that the structure of the stop-loss order book may be used by such an agent to inform trading decisions and to generate volatility within markets for their benefit. Finally we demonstrate how the agents closing strategy effects both the profitability of the agent, as well as the price trajectory of the market.