The easiest way to describe this is with an example. Let’s take EUR/USD yesterday as an example. The price was sitting around 1.3060 for much of the day but interbank dealers, many of whom chat with each other, all had pretty similar order books with heavy stops below 1.3000.
The dealers faced two obvious paths:
- Do nothing until the stops are triggered and then start selling to fill the orders. Remember that the dealers know there are plentiful stops below that level. Once 1.2999 deals, the dealer must start selling. If he’s got EUR300 million worth of stops, they will probably not be filled better than 1.2990 on average? The dealer makes no money and the customers are very annoyed at the bad fill!
- The other alternative is to start selling in increments as the price starts falling. It could be something like this; sell 20 at 1.3060, sell 20 at 1.3050, sell 20 at 1.3040, buys back 30 at 1.3030 when price starts to stall, starts selling again more intensely once 1.3020 breaks, selling 30 at 1.3015, 50 at 1.3010, 100 at 1.3005 and then sell really hard through 1.3000 to ensure that the stops are done. This way, once 1.2999 deals (and he will make sure it does) the stops are filled at 1.2997, the customer says ‘good fill, not happy but good fill’ and the dealer makes $400k profit!
That’s why dealers chase stops.