Part two of my post on stock trading basics is actually a lot less basic than part one, and I think it’s something all beginning and intermediate investors need to hear. Today I’ll finish my discussion of the four basic types of stock trade orders with two that only pertain to selling stock: stop-loss and stop-limit orders.
Making the decision to sell an investment is a lot harder than making a buy decision, which is something most professional investors will tell you. I’ll talk more about this in a post due to hit my blog next Monday (Aug. 31) called Parting is Such Sweet Sorrow, with all due apologies to that great stock trader and even greater writer, William Shakespeare. But until then, we’ll talk about a few trade orders you can place whereby you don’t have to make the direct decision to sell your stock; the orders do it for you.
The two types of orders we will discuss today are very similar, but have one critical difference. The first is called a stop-loss order. This type of order is designed to help limit the money you lose on a falling stock. How it works is this: say you own a stock that is currently worth $50 per share, and you have decided you are not willing to take any more than a 10% loss on it, which means the lowest you would want to sell the stock for is $45 (10% of $50 is $5; $50 minus $5 equals $45).
So, if you don’t pay too much attention to the stock market or the current prices of stock you own, to prevent your stock falling below $45 with you still owning it, you can put in an order to sell the stock automatically when it hits $45. That way it won’t slip below the lowest price you’re willing to accept for the stock without you knowing about it and selling it in time. Sounds like a great idea, right?
Well, there are a few things you should know before you rush to your brokerage app to place stop-loss orders for every stock you own. How this type of order really works is this: if your stock trades at or below the stop-loss price you set, it doesn’t automatically sell: it turns into a market order to sell at the next bid price. If, using the above example, your stock trades at $45 (and turns into a market order to sell), and there is nobody else willing to buy that stock from you at $45, it will wind up selling for less. If the stock is falling rapidly, you might actually wind up getting $44 per share or even $43 (or less) for it.
This probably doesn’t sound like that big of a deal to you, and no, it’s not the end of the world if it happens. It’s extremely unlikely your stop-loss order for $45 will turn into a sell at, say, $25, or even $0. The point here is that stop-loss orders don’t give you the iron-clad protection against falling stock prices that most people think.
But there even bigger point is that, once your stop-loss-turned-market-order does kick in, you’ve sold the stock regardless of where the price goes from there. What if it winds up going back to $50 by the end of the week? You’re already out at $45 or less. Much more on this in next week’s post I mentioned above about selling stock.
To wrap up for the day, I’ll tell you how the similar stop-limit order works, which it probably won’t surprise you to hear I’m no bigger a fan of. With a stop-limit order, if your stock hits your “stop” price ($45 in the example we’ve been using all post), it turns into a limit order instead of a market order. So to place this kind of order, you need to set two prices: your “stop” price, which is the price that triggers the next action, and your “limit” price, which is the lowest price per share you are willing to sell the stock for. If you are adamant that you will not accept less than $45 per share for your stock, and you set both the stop and limit prices at $45, you might not sell your stock at all with this type of order.
Why? Using the scenario I already described where there are no more buyers at $45 once it has hit that price, your stop-limit that has turned into a limit order of $45 will not execute, since there are no more buyers at that price. If the stock does continue to fall and you’re not paying attention to it, you could discover that not only do you still own the stock you wanted to sell at $45, it could now be worth only $40, or $35, or less.
To try to circumvent this, many traders will set their limit price slightly below their stop price. So you might still want to set your stop price in our example at $45, but set a limit of $44 or $43 so that you have a better chance of selling the stock rather than see it fall a lot further with you still owning it. But there is no guarantee there will be willing buyers at $43 or $44 any more than there is at $45.
The bottom line is, the types of orders we’ve talked about today do not provide you as much protection as many investors think. Many investment advisors and websites such as Investopedia love them, but I do not. However, I will say this: If you truly can’t accept seeing your stock fall by a certain percentage, and you really don’t want to watch your stock’s price too often or do much of your own research, then using a stop-loss is ok as long as you realize you might not get the exact price you want when your sell order executes. Next week though I’ll show you what I think a much better strategy is.
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