By Peter Mastrantuono
A stop order is a contingent order that can be used to establish or exit an investment position. It can mitigate downside risk or initiate a position at a predetermined price level.
There are three variations of stop orders: stop-loss, buy-stop and stop-limit orders.
The Stop-Loss Order
A stop-loss order is triggered when a stock moves below a specified price. For instance, an investor owns 100 shares of XYZ. XYZ’s current share price is $100, well above the investor’s cost basis of $50 per share. The investor would like to continue holding XYZ but is worried about a sudden decline erasing some or all of his or her gain.
In this example, the investor places a stop-loss order at $90 per share to protect the bulk of his or her unrealized gain. If XYZ’s shares fall to $90, the stop-loss order will convert to a market order, and the shares will be sold at the prevailing market price. This is an important point. Even though a stop-loss order may be set at $90, it doesn’t necessarily mean that the investor will receive a $90 per share price. In a declining market, the investor may receive a price below $90.
A stop-loss order is also used to limit losses when creating a new position. For instance, if an investor decides that he or she does not want to risk more than 10% on a particular trade, his or her buy order on a $100 per share stock can be accompanied by a stop-loss order of $90.
There are a number of other portfolio risk management strategies available to investors, which the investor may want to explore.
The Buy-Stop Order
A buy-stop order is a conditional order to buy a stock and is entered at a price above the current price. One reason an investor may use a buy-stop order is that, based on his or her reading of the technical charts, a stock looks set to break through a resistance level and move higher. However, if it fails to do so, the investor has no interest in buying these shares. In such a case, he or she may place a buy-stop order at a price just above that resistance level.
A buy-stop is also converted into a market order, so an investor is not guaranteed getting the shares at the buy-stop price. In a fast moving market he or she may end up paying a higher price than anticipated.
The Stop-Limit Order
One of the risks of stop orders is that they can trigger a purchase or a sale at an undesirable price.
The stop-limit order is used to eliminate this possibility. Rather than the stop order becoming a market order, the stop-limit order becomes a limit order.
Here’s an example. An investor places a stop-limit order to buy at $100 per share, but with a limit price of $105, i.e., once the $100 per share price is reached, the trade will only be executed if the order can be filled for a price under $105 per share.
Investors should note that stop-limit orders may not get executed since a brokerage firm cannot sell a stock at a price lower than the limit price or buy a stock at a price higher than the limit price.
Stop orders may be appropriate for many investors across a variety of investing scenarios. A financial advisor can be valuable resource in gaining a better understanding how and when to implement them.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.