Stop Orders

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The other side of the limit order is the stop order. By using a stop order, an investor limits fluctuation of the price at which he or she is willing to own the stock. Or, in other words, the stop order is used to keep an investor from losing money he or she has already made on long and short positions .

Long:

A long position simply means that an investor owns a share of stock outright and has full rights as pertain to that ownership.

Short:

A short position means that an investor has sold stock that he or she has borrowed with the intention of returning the stock by repurchasing it at a later time when the price of the stock has dropped.

Say, for example, that you have already purchased 10 shares of XYZ Company at the price of $10. Luckily, the price of XYZ Company has risen since you purchased it to the price of $20 per share. This is no surprise to you, because you expected the value of the stock to rise, or you wouldn't have purchased the stock to begin with. The stock you purchased that was originally worth $100 is now worth $200. Lucky you!

Plain English

Using a stop order, an investor seeks to cover a short position by instructing a broker to sell stock at a price lower than the current market value or to buy stock at a price higher than the current market value.

But let's also say that you have a sneaking suspicion that the price of XYZ Company will go up for a while and then drop. And, different from the limit order example, you believe that once the price begins to drop, it will not go back up again. You want to protect the $100 profit you have already made. To do this, you give your broker a sell stop order. By doing this, you tell your broker, "Should the value of my stock drop below $20 per share, I want you to sell all my stock automatically."

This way, should your stock drop below $20 and you can't get to a phone to yell "Sell! Sell!" as they do in the movies, you're already covered; your broker has received standing instructions from you and should be trying to sell your shares.

You should be aware of three more lines of small print regarding the sell stop order.

If you had bought each share of XYZ Company's stock for $10, you obviously couldn't put a sell stop order on it for $20, since by definition the stock meets that criterion as soon as you purchase it. To deal with that, most investors give progressively higher sell stop orders as the price of the stock continues to rise. So, upon purchasing the stock, you would place a sell stop order with your broker for, let's say, $9. Once the price of the stock rose to $12, you would place a sell stop order for $11, and so on.
If your stock is a volatile one, you could be shooting yourself in the foot without knowing it. As is often the case with volatile stocks, a stock may drop in the morning but rise later in the day. For example, should the price of XYZ drop below the sell stop order price in the morning, your broker will try to sell it. Should the price jump in the afternoon as everyone notices the price drop and thinks the stock is a bargain, you may lose out on the price increase ”because you may no longer own that particular stock, thanks to your extremely efficient broker.
In each of these transactions, remember that service charges would apply, and we've discussed how these can quickly eat away any or all the profits you may have actually made with your trading.

A buy stop order is a little more complicated since short positions are involved. Should you need a refresher, a short position works like this. Say the price of XYZ Company stock is at $10. You believe the price will go down to $5. A short position will allow you to actually make money from the decline in the stock price. You would " borrow " 10 shares of XYZ Company and sell them at the price of $10. When (if) the price did actually drop, you would purchase 10 shares at $5, return them to the market where you borrowed them, and pocket the $50 difference.

A buy stop order would function to keep you from losing money in this transaction too. Say you have borrowed and sold the stock, and the price drops to $5. You place a buy stop order with your broker, telling him or her to purchase the 10 shares if the stock price rises to $6. Although you will make less than in the $5 example, the buy stop order will keep you from losing even more if the price of the stock continues to rise. The $40 you pocket by repurchasing the stock at $6 isn't as good as the $50 you would have made by repurchasing the stock at $5, but it's better than the $30 you would have pocketed had the stock risen to $7 and you hadn't had the buy stop order.

All three of the small-print examples regarding the sell stop order also apply to the buy sell order. Successive buy sell orders are required as the price of the stock continues to drop. Minor fluctuations may animate these orders and keep you from making the same profits you would have realized had you sat tight. And those darn service charges keep adding up and adding up.

TIP

Stop orders may possibly limit your ability to make money, but they will definitely protect you from losing money. For this reason they are particularly popular with new investors.

The 30-Second Recap

Round lots are the standard number of shares grouped together for trading, usually 100 shares for common stock.
Odd lots refer to trading shares outside of round lots, that is, piecemeal or individually.
Time notation refers to an instruction to your broker as to the time frame within which each of the following orders must be filled.
A market order is a direction to a broker to go to the market immediately and purchase the selected stock at the best price currently available.
A limit order is a direction to a broker to purchase stock should the price fall from its current price or sell it should the stock price rise.
A stop order is a direction to a broker to sell stock at a price lower than the current market value or to buy stock at a price higher than the current market value for the purposes of hedging losses or covering a short position.

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