The Common Sense Investor

Stop market orders are a tool to help you sell high and buy low.

Standard market orders, which are issued to brokers and instruct them to buy or sell stock, are liable to be influenced by a change in the current market price, leaving an investor either happily better off than they expected to be, or unhappily worse off. So how does the cautious investor guarantee against loss?

One option is a limit order, which instructs the broker to sell and buy at specified prices and not to drop below them when selling; not to go above when buying. Another option is a “˜stop market order’. This order involves the investor investigating an appropriate price at which he would wish to buy or sell, and instructing the broker to buy or sell when the market price reaches this value. It then enters the market just as a normal market order would, and the broker finds the best available price.

To understand the nature of a stop market order more specifically, consider the two types that are available: 1) a “˜sell’ stop order, and 2)a “˜buy’ stop order.

A sell stop order involves the investor instructing the broker to sell stock at the best price available if it declines below value X. By doing so, an investor knows that he or she will not lose substantially more than X (for the broker has to find the best available price and cannot guarantee X) when the price of his or her stock is in decline. The secure investor has effectively “˜stopped’ losing more than he or she can afford, and risk is contained.

Yet a stop market order is not just a pessimistic financial tool, and has a good function for the investor looking to make a profit. If the investor has seen the value of his or her stock increase significantly but doesn’t want to sell just yet, he may then place a stop order to ensure that the stock is sold if it then declines in value below a certain price. This guarantees a certain amount of profit, and should be considered carefully by those who have made money with shares.

A buy stop order is used for the opposite reason: by keeping the buy price below a certain level. It stops the investor from losing money by specifying a price the broker should buy at, thus protecting themselves from the danger of the price rising too high. This is particularly useful for the investor selling a “˜stock short’, in which borrowed stock is sold with the aim to buy it back at a lower price, as it “˜stops’ too much loss from the gamble not paying off.

So with stop market orders you have a little more certainty, safe in the knowledge that your broker will stop loss by following your instructions. There is no need to consistently check how your stock is doing, as you are guaranteed not to lose out by any more than you have already specified.

There’s some old gambler advice that applies here (although we like to point out that investing is not the same as gambling): never risk more than you can afford. Stop market orders make sure this is the case both on the buying and selling end of a trade.