Using A Stop Order

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Active investors who are in the market for capital gains, and who keep a close watch on price trends, frequently use a device known as the "stop order" to help protect their profits or limit their losses. The stop order first appeared some 50 or 60 years ago, and for most of its life has been popularly referred to as the "stop-loss" order. Because there are no guarantees—real or implied—against loss in any market, however, the New York Stock Exchange now insists on the term "stop order."

Here is how it works. Let's say that you bought 100 shares of International Nickel at 97, and that it is now at 110. To give some measure of protection to your thirteen-point gain, you enter a stop order to sell at 104. If the stock should drop to this level, your stop automatically becomes a market order to sell, thus preserving seven of your 13 points. If, however, the stock should continue to advance, the stop can be moved upward, point by point, behind it. At 115, the stop could be pegged at 109. At 119, it would be 113.

A stop can also be entered at the time of purchase, to try to limit losses. This is a favorite maneuver of margin buyers. An order to buy, say, at 70, is accompanied by an order to "sell at 67 stop." If the stock advances, the stop is moved up a reasonable distance behind it. If it drops and the buyer is sold out, his loss, hopefully, is minimized to $3 a share.

On the short side, the stop serves the same purpose. If you have sold Nickel short at 110 and it is now at 104, your six-point profit can be somewhat protected by a stop order to buy at 107. Should the decline continue, the stop can be lowered behind it. If it should turn around and advance to 107 or beyond, the stop is caught, and the shares necessary to cover the short position will be bought.

Or, again, the stop can be entered at the time the short sale is made, to limit losses in the event of a rise.

Unfortunately, there are no sure things in the stock market. Used with keen judgment and a sensitive touch, the stop order can afford the protection just described. However, it can also work out adversely.

If the stop is placed too close to the market—and two points away is the usual peg—it is quite possible that the market will dip briefly, catch the stop, and then march briskly upward before the buyer can get aboard again. Specifically, if you have a 6-point profit in Nickel at 102 and place a stop at 100, a momentary decline could sell you out with only 4 points realized, while the stock, meanwhile, is jumping to 108 or 110. Even if you reacted swiftly enough to benefit from the rise, part of it would be absorbed by commissions on the stop sale and the necessary repurchase.

Likewise, in a thin market, a stock can fall through a stop so fast that a considerable loss may be taken before the sale is effected. For the stop cannot guarantee that you will receive the indicated price. You will get your price if the stock pauses at that level. Otherwise, you are sold out at the first available resting place, which may be several points below what you anticipated (on the long side; above on the short side), thus cutting your profit margin.

In summation, it is vitally important that the investor know how to use a stop-order, but equally important that he use it with caution. For as we've seen, stocks can sag and then quickly surge, losing the investor potentially hundreds, if not thousands, of dollars.

This article is a small snippet from www.stocktradingonline.org

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