If you ever have the chance to visit the exciting and dramatic floor of the New York Stock Exchange for the opening bell you’ll see that it’s a thrilling, adrenaline-fueled event. When the bell sounds the action starts with a frenzy.
There is an old saying, however, that no alarm bells go off to signal the end of a bull market. Just when it looks like the party is reaching the high point, the bottom can fall out, turning your stock market gains into miserable losses. The abruptness and violent volatility can be like the plot twist in an Alfred Hitchcock movie. One moment everything is calm and ordinary and then horror jumps off the screen and puts your heart in your throat.
Experienced investors know that at times like these, when the bulls are extending their long and lucrative run, it is wise to start calculating your Plan B. You need to locate the exits, prepare a contingency strategy, and not get caught in the middle of a selling stampede if and when the markets get spooked and panic. Fortunately, there are some practical ways for even the novice investor to protect their gains and help avoid a potentially devastating loss. One of the most basic tools you can deploy is the Sell Stop Order and a variation of it known as the Sell Stop Limit Order. Let’s get to know these important stock market terms.
Just like “buy” and “sell” orders where you ask your stock market representative to purchase or sell a stock at a particular price, stop orders accomplish a similar outcome.
A “Stop-Loss Order” is an order to sell stock once the stock price drops below a certain level or cut-off point. If you want to sell your stock if the price per share starts falling below $40, for example, you can establish a stop-loss at $39. As soon as the stock trades at that price, the stop-loss goes into effect and issues an order to immediately sell at the going market price – whatever that may be.
Let’s take a look at one example:
- Let’s say that the stock in our example hits $39. The stop-loss order kicks-in and the trader at the stock exchange immediately sells at the market price.
- You may get $39 a share as long as there are buyers ready to pay that much. Otherwise the price will be filled at the next best price that is available. You don’t know exactly what that price will be until the transaction is completed because the share price is subject to market fluctuations and buyer demand.
- In a calm and stable market, as long as your stock is a popular one, the chances are good that you will get close to the price that triggered the stop-loss order.
- In a rapidly crashing market, however you might get much less than $39 because it may be hard to find anyone willing to match your asking price. Since you ordered the stock trader to sell at the market price then you are subject to whatever price that is at that particular time.
Stop Limit Orders
Those who are worried that they won’t get a high enough price because of a rapidly falling market can be more specific. In this case you will use what is known as a “Stop Limit” sell order.
The “Stop-Limit Order” works the same way, triggering a sell order at a certain price point, except that it only authorizes the trader to sell at a specific price that you ask. Say that you do not want to accept a sale any lower than $35, but you want to trigger a sale if the stock gets as low as $40. You then establish a Stop Limit order at $40 with the limit being $35. The trader executes your order at $40 and tries to sell your stock at the highest possible price, but will not offer your stock for sale at any price lower than $35.
The risk to using this kind of order is that there is no guarantee anyone will buy at or above your limit price. If the market is descending and the highest price anyone wants to pay is $34, for example, your stock won’t be sold because you only gave permission to sell for a minimum of $35. The danger there is that the stock could theoretically keep plunging in price – as the value of the investment you keep holding on evaporates as it did for many blue chips during the last crash.
Investors also use these kinds of orders to limit losses without having to keep a constant eye on the market. In our examples, for sake of simplicity, we used whole numbers. You may issue fractional price orders, though, such as $39.50 or $34.75 price points.
As you can see, there is no foolproof way to safeguard your investments, but there are tools that can definitely help you have more control over what happens. Using stop-loss orders and stop-limit orders is kind of like carrying a spare tire. Most people will find that it saves them a lot of trouble if they get a flat tire, although it does not guarantee you will not get a flat tire and doesn’t guarantee that your spare won’t also go flat. Having said that, however, most experienced drivers would agree that it is a smart idea to carry a spare. Similarly, wise investors often take advantage of tools like stop-loss orders to limit losses and improve their chances of success.
Talk to your broker to learn more, and if you decide to place a stop-loss order be sure that you don’t just forget about it. Later your financial goals or reasons for owning the stock may change, and you may need to update your orders or revoke them in order to stay current with your financial planning.