Marc Cuniberti: What are stop and stop limit orders?
July 8, 2018
Stop and stop limit orders are a common term often used by financial professionals although many retail investors (mom and pop on Main St.) may not have heard the terms let alone know what they mean.
The term "stop" means a predetermined sell point is selected by an investor. An example might be John Smith, a typical investor, buys a stock at $100. He is nervous about losing a lot of money so he decides if the stock drops to $90, he will sell it. He can sell his stock in a variety of ways.
He could just watch the stock and when it hits $90, call his broker and instruct them to sell it at the best price available. That is generally referred to as a "market order to sell" and it means once you enter the sell order you get the next best price when your order hits the front of the line.
If the stocks sells at $90 (which it may not using a market order) that would mean a 10 percent loss. Because markets are always moving however, prices are always changing and you may get a different price with a market order.
There are other types of sell orders one can execute.
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Another option would be a "limit order" which can be entered on the buy or sell side. If Smith wanted to sell his stock at $90 and won't accept anything lower, a market order would not guarantee that. If he wants $90 and no lower, he has to enter a stop "limit" order. That instruction tells the market makers (the folks that execute the trade) that you want $90 and no less. In that case, if the stock is falling when your order moves to the front of the line, if the stock had dropped below $90, your order will not get filled.
In other words, you didn't sell your stock and you are basically "still in." This means Mr. Smith, although he wanted to limit his losses, didn't get out at all and the stock could keep falling with Smith still onboard for the ride. Obviously not much protection if limiting losses was his initial goal.
If Mr. Smith wants to protect against devastating losses and get out as close to his price as possible, he would use the order that gets him out at any price and enter a "stop" order (versus a stop limit order). Smith would get out but as what price would be unknown until the order is filled and reported. Think of a stop order as jumping off a train and not knowing where you'll land but you will certainly get off at some point.
Which strategy will you choose?
How you implement your sell strategy can be done in a variety of ways. You could just wait, watch and then act when the stock hits your price by calling your broker or hitting the sell button on your computer screen as a market order, but that would entail a constant vigil, watching the stock every second the market was trading. Not really an option for most.
You could also enter a sell order with your broker anytime and then the three options are a "market order," a "stop" order or a "stop limit" order.
The market order gives you the next price available as soon as you enter it. The stop order will get you out at some price at or below or in some cases even above your predetermined price and a stop limit order will get your price if executed but you might not get out at all.
In addition, although all sell orders are designed to get an investor out at a certain price, as in all things run by man, the systems are not foolproof. Regardless of what type of order you place, you will only know how it worked after the trade executes.
As we've seen all too often in the past, sometimes markets don't work exactly as designed.
This article expresses the opinions of Marc Cuniberti and are opinions only and should not be construed or acted upon as individual investment advice. He is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at 530-559-1214, or SMC Wealth Management, 164 Maple St #1, Auburn. SMC and Cambridge are not affiliated. His website is http://www.moneymanagementradio.com. California Insurance License # OL34249. Indexes may not be invested into directly and consider consulting a qualified financial advisor if you have any questions or concerns and before making any investments decisions.
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