Start the conversation
Now that you’re ready to start buying stocks, we have three simple but essential tools that will help you maximize every single investing dollar. They’ll also protect your money if the markets dip.
With these three tools, you’ll be just as confident investing as any “professional” on Wall Street.
As you saw in the last lesson, there are three basic order types: market, limit, and stop orders. Every other order type is an extension of these basic three.
A market order is the simplest. It instructs the broker to execute the trade right now, at the best possible price. Keep in mind that a market order does not have a price limit, so if the share price drastically changes between the time you request the trade and when it’s executed, you could pay more than you wanted.
Market orders are best used for large-cap stocks with very high volumes, like Apple. You can usually get in or out of your investment instantaneously with a market order. These orders are not recommended for stocks with low volume.
Thinly traded stocks can have large discrepancies between the bid and ask price. So not only will it take longer for your order to go through, but you may end up paying a very different price than when you placed the order.
Because of those issues with market orders, stop and limit orders can be extremely helpful.
A limit order is intended to help you get more upside and allows you to buy/sell at a specific price or better.
And think of a stop order as a tool to help limit your losses if prices start moving against you.
You can use limit orders when you are buying or selling. With a buy limit order, you indicate a specific price that’s the highest you are willing to pay for those shares. Typically, you set the limit order at a price below the current market price, so you get to buy the shares when the stock pulls back.
A limit order is perfect to use when you’re bullish on the stock long term, but you want to pay a lower price than where it is trading. If the specified price cannot be reached, the order won’t be filled.
Here's a perfect example: Let's say you want to buy XYZ stock because you think the stock is going up over the long term. XYZ currently trades for $130 per share. But you believe that at $130 per share, XYZ stock is overvalued. You think it’s a good buy at $125 or lower. You would then place a buy limit order at $125 on XYZ. If/when the stock reaches the limit price, the order becomes a market order and is filled at $125 or below.
A sell limit order is a great way to maximize profit taking. It tells the broker to sell shares at a designated price or better. This is good for when you would like to sell your shares, but only at a specific price or higher. The limit price is the minimum price you are willing to accept in order to sell your shares.
Sell limit orders are such valuable tools because they allow you to lock in profits. If a stock jumps quickly, this tool will automatically sell your shares at a profit for you. This way, you don’t have to check in on your stocks every 10 minutes to make sure you aren’t missing a good time to sell.
Just as with a limit order, a stop order can also be used when you are buying or selling.
A buy stop order, just like the limit order, tells the broker to execute the trade at a specified price that’s different from the current market price.
In this case, the buyer places a stop above the current price. It’s good to use when you’re bullish on the stock, but you want to see it start to rise before you actually buy.
Now, if this seems counterintuitive, it is. After all, why would any buyer take a higher price over a lower one?
The answer is momentum.
With a buy stop order, an investor is taking advantage of expected upward momentum in the stock and wants to be first in line once the price momentum is confirmed. By the time other investors are logging in to their accounts, you are already riding the upward trend!
Here’s an example: Let's say XYZ stock currently trades for $130, and you like the stock, but you want to see it move higher before you really believe it’ll keep going.
You place a buy stop order at a price higher than $130, maybe $135. Once XYZ stock reaches $135, the buy stop order becomes a market order, and your request is filled at the next best price.
The last basic order type is a sell stop order, also known as sell stop-loss order.
The sell stop order is intended to protect you from steeper losses if the stock falls. It’s placed below the current market price.
By placing a sell stop order on the shares you own, you are telling your broker to sell a stock below the current price. Once the stock trades at or below the price you specified, it becomes a market order to sell.
For example: If you buy XYZ stock at $50 per share and set a sell stop order at $45, you will be sure to get out of the stock if it falls to $45. Or you may have bought the stock at $50, enjoyed its climb to $70, and want to make sure you keep some of those gains, so you set a stop order for $60, just in case it starts to go back down.
What you don’t want to do is set a sell stop order too close to where the stock is currently trading when you’re just buying it. Any stock can dip a few dollars in price and then bounce right back up and never look back.
A good rule of thumb is to set a sell stop order between 10% and 15% from your purchase price. This way, you will avoid losing the majority of your investment if the stock drops unexpectedly. But you also won’t get stopped out of the stock if it drops just a few percent either.
Stop and limit orders are powerful risk management tools. But you can have even more control over what you pay for stocks when you combine the two.
Keep in mind that a stop limit order requires two prices, both a stop price and a limit price. Together, they make a range above or below a stock’s current market price.
A buy stop limit order is the same as a buy stop order; the only difference is the addition of a limit price, which caps the purchase price. It has two advantages:
- It allows you to buy shares before they move up too far from where they currently trade, so you don’t miss out on too much profit.
- It lets you define the price you are willing to pay.
By giving your broker a stop price and a limit price, you not only control the maximum price you are willing to pay (the limit price), but also control when your trade is filled (the stop price).
Here’s an example: XYZ stock is trading at $130 per share, and you would like to buy it once it shows signs of upward momentum. But you don’t want to pay too much more than its current price. You set a stop price of $135 and a limit price of $140, for example, so you won’t pay more than $140 per share.
If the stock price moves above $135, the stop order turns into a limit order. The order will only be filled if the stock is below the limit price, in this case $140.
A sell stop limit order tells the broker to sell a stock given certain price parameters. As with the buy stop limit order, the sell stop limit order gives you control over the price at which the stock is sold and the minimum price you are willing to accept.
The investor using a sell stop limit order benefits from a limit on the maximum possible loss, without setting a limit on the maximum possible gain.
Once the stop price is hit, the stop order becomes a limit order and instructs the broker to sell the security at the limit price or higher.
With a sell stop limit order, an investor is placing a floor on the lowest acceptable selling price if a condition is met.
Here’s an example: You own shares of XYZ stock, which currently trades at $130. You bought it for $100 and you want to sell if it starts falling, so you can keep most of your gains. You would place a sell stop limit order below the current trading price, so maybe $125. You would also set the lowest price you are willing to accept for a sale. In this case, the limit is $122.
If XYZ stock drops to $125, the sell stop limit order becomes a limit order. Your order would be filled at the next best available price as long as the stock still trades above your specified limit price of $122. If it keeps falling past $122 before your order is executed, the order will expire.
Some people avoid investing because they are afraid of losing money. But the tools we’re going over now will help you keep more of your gains and limit any losses. And this next one acts as a “backup” that protects your money if a stock starts to drop quickly.
Trailing orders are set to move with the share price. They’ll go up as a share price rises, so you keep more of your gains.
And there is one particular reason why trailing orders – trailing stops in particular – are such a great tool.
Trailing stops take emotion out of investing, which is key to making money – and something many investors fail to do.
Numerous studies in behavioral finance have shown that people have trouble cutting their losses. It seems we stay optimistic even as our returns approach zero, and we hang on to losing stocks for too long. Setting a trailing stop when you buy a stock, or shortly after you buy, prevents you from falling into this behavioral trap.
When you’re buying stocks, you can use trailing orders in one of two ways. You can set a trailing stop or a trailing stop limit order.
A trailing stop order is similar to a stop order. The only difference is that the trigger price in a stop order stays the same, while the trigger price in a trailing stop order changes as the stock’s price changes.
When you’re selling a stock, you can place a trailing stop to sell order below the market price so you can get out of the stock if the stop price is reached. The stop price will rise as the market price increases, but will remain unchanged as the market price drops.
The stop order becomes a market order once the market price hits the stop/trigger price.
The benefit of this type of order is it lets an investor set a limit on the maximum possible loss, without setting a limit on the maximum possible gain.
Here’s an example: You own ABC stock, which currently trades for $10. By placing a $3 trailing stop, you are effectively capping your losses. If the stock drops to $7, your order will be filled.
However, if the stock increases before it drops, the stop price will be reset higher, so it remains $3 below where the stock is trading. If the stock increases to $15, the stop order is now $12.
Trailing stops can be set as dollar or percentage amounts. The key is to set the level amount at a level that is neither too tight nor too wide. If the level amount is too close to the current price, the chances of being stopped out of the trade too early increase. If the stop level is set too wide, you will lose too much of your gain. At Money Morning, we typically use about 10-15% trailing stops, although there are exceptions.
A trailing stop to buy order sets the trigger price above the market price by a specific trail amount. The order is activated when the market price hits the trigger price.
As the market price decreases, the stop (trigger) price also decreases. However, once the market price starts climbing again, the trigger price holds firm. (See the picture to the right.)
Once the market price hits the stop price, the order converts into a market order to buy at the best available price.
Here’s an example: You have your eye on a stock that trades at $20, but over the last month, it has dropped to $10. You love the company and think it’s a great stock for the long term, but you don’t want to buy in while it’s falling – you want to buy after you feel it has leveled off. You feel like a $3 gain in share price is a sign that the stock is done falling so much. So you set a trailing stop to buy order of $3.
The order will be executed any time the security gains $3 over the lowest market value. If the stock rebounds immediately, the order would go through at $13. If the stock keeps falling all the way down to $5, the order will go through when it rebounds to $8.
This ensures that you never have to “time” buying or selling a stock again. Forget watching the ticker all day, too. The trailing stop to buy order will do the work for you.
The second type of trailing order is a trailing stop limit order.
A trailing stop limit order works the same way as a trailing stop order, but when the designated price is reached, a limit order – not a market order – is triggered.
Adding the limit price lets you indicate the lowest price you are willing to accept when selling, after the price has already dropped by a specified trailing amount.
A seller is saying, "If the bid price falls to my trigger price, I want to sell, but I only want to sell if I can get this limit price or higher."
Here’s an example: You currently own ABC stock, which trades for $100. You are starting to lose confidence in its long-term prospects, but you aren’t ready to sell. In order to limit your losses if ABC does fall, you instruct your broker with the following: Trailing Amount = $20 and Limit Offset = $5. The Limit Offset tells the broker how much less than the stop price you are willing to sell for.
As the market price increases, the stop price and limit price will increase by that predetermined amount. However, the stop price will remain unchanged as the market price decreases.
Let’s say the price drops to $80. The stop order will become a limit order, instructing the broker to sell at $75 or higher.
On the other side, you have trailing stop limit orders to buy. However, these are normally only used as a hedge for investors shorting a stock.
As the market price increases, and ultimately hits the stop price, the order becomes a limit order to buy at the limit price, which is set higher than the stop price. The limit price is based on the predetermined limit offset amount, telling the broker the highest price at which the investor is willing to buy.
With a trailing stop limit order to buy, an investor wants to buy at a higher price, but only up to a certain point, or the limit price. That gives them higher upside when they short the stock.
There are just a few more orders to consider: conditional orders. They're easy to learn, and they can all be grouped together because they are all very similar.
Conditional orders work alongside the market, limit, and stop orders we just laid out.
These orders account for issues like trading volume and how long you'd like the order to be active. They provide a bit more specific guidance and instruction to your brokerage.
Now that you’re equipped with these tools, it’s time to start picking the stocks you will be adding to your portfolio.