A Question About Stop Losses

Q: Trader X buys stock ABC at $3.00. X sets a stop loss at $2.80. The following day, stock ABC opens at $2.65. Does it get sold?

A: You obviously do not want to stay in the market for an unlimited amount of time if your capital is limited. A stop or limit order tells your broker you dislike the current price, and you want the price to move up or down before you buy or sell.

First, let's differentiate between a stop loss order and a limit order. A stop order means that a trade is initiated when the security you want hits a particular price. When the price is reached, the stop order turns into a market order and is filled. What does this mean? A market order is filled at the "best possible price," not the price you, the trader, necessarily want. The best possible price may be lower or higher.

Say Trader X buys stock ABC at $5, and ABC is now trading at $10 per share. Setting a stop order at $7 guarantees that Trader X profits at around $3 per share. However, if stock ABC fluctuates by 15 percent weekly, a 10 percent stop below the current price would cause the order to be triggered at a bad time.

A limit order is an order that pegs your buying or selling price at a maximum or minimum value. For example, Trader X wants to buy stock ABC. It is currently trading at $13. X wants a limit order of $10, ensuring that he will not pay more than $10 for this stock. When ABC hits $10 or under, X buys a set number of shares. X nows wants to sell. He owns stock ABC which is trading at $13. He places a limit order to sell at $15, ensuring that ABC will only be sold at $15 or over.

A limit order guarantees that trading is made at the price you want. On the other hand, the order may not go through at all if your set price is not reached.

So back to the question. Trader X buys stock ABC at $3.00 with a stop order at $2.80. ABC opens at $2.65 the next day. Does ABC get sold? No, ABC is not sold if the stop loss trigger is at $2.80; ABC is sold at market open if the limit price is at $2.65 or below. On the other hand, if Trader X's stop loss trigger is at $2.80, and limit price is at $2.70, then the stop loss order executes a sale order at $2.70. It will remain at $2.70 until buyers bid up to $2.70 and up or until the order expires.

But say Trader X is adamant at selling ABC only at $2.80, no ifs or buts. The market opens at $2.20 the next day because a meteor hit the main ABC production plant. In other words, no buyers. It's only logical for X to set a stop trigger at $2.20.

Stop losses do not guarantee zero losses, they simply reduce risk by ensuring you have an exit plan in place.