Stop Order
A stop order is an instruction to buy or sell a stock whenever the
stock trades at or past a specified price, when it then becomes a
market order. You can use a stop order to protect existing profits or
reduce losses. Although a stop order might appear similar to a limit
order, they have some differences.
A stop order differs from a limit order in that after the stock’s
price reaches the stop-order price, the stop order becomes a market
order. Suppose that you buy some stock at $20 per share that is
now trading at $30 per share. Selling those shares would result in a
$10 per share profit. To protect this profit from a rapid price drop,
you can place a stop order to sell at $28 per share. If the stock drops
to $28, the stop order then becomes a market order and is executed
at the prevailing market price. If the stock is sold at $27.75 per
share, you have protected a profit of $7.75 per share. On the other
hand, if the stock keeps increasing from $30 per share after the stop
order is placed, the stop order lies dormant (if it has no time limit
and is a GTC order) until the share price falls to $28.
Similarly, you can protect profits on a short sale by using a
stop order to buy.
In addition to protecting profits, stop orders can be used to
reduce or prevent losses. Suppose that you buy a stock at $10 in
anticipation of a price increase. Soon after your purchase, news
from the company suggests that the price may go down rapidly.
You can place a stop order to sell at $9, which limits your loss if the
stock price declines below $9 per share. Limiting losses on a short
sale is the other use for stop orders.
Another danger awaits when you are setting a stop-order
price. If you place the stop-order price too close to the current price,
a temporary surge or fall in price of the stock can trigger execution
of a market order. Then, although the stock price might move back
in the direction you anticipate, you no longer have a position in
that stock. On the other hand, if the stop-order price is set further
away from the current market price, less profit is protected (or you
risk a greater loss).
Of course, the use of stop orders does not increase profits if
you do not correctly anticipate the direction of the market price.
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