Sunday, February 22, 2009
So, I guess I have to follow that last post with a discussion of buy-stop and buy-limit orders. Let's say you've been watching Starbucks lately. It last traded at $9.58 on Friday, so for whatever reason this price intrigues you. But, just like the older folks who attended my garage sale last autumn, you can't just buy something on the cheap. You insist on buying it even cheaper. No matter what price tag somebody sticks on a stock or a used waffle iron, frugal folks like you still insist on buying the thing a little cheaper. Fine. If you insist on buying Starbucks (SBUX) for $8 or lower, place a buy-limit order @8. Once you do that, you'll be in a position to buy SBUX as soon as the ask price drops to $8 or lower. What if the price drops to $8 or lower, filling your order, but then keeps dropping to, like $3, or, like, $1? At that point you would be crying and wishing you had placed a buy-stop order instead. Why? With SBUX trading at $9.58 a share, let's say you were intrigued but still nervous about the company's near-term prospects. There's a recession on, and it's not that hard for most people to cut back on their unnecessary spending. So, you're not ready to dive in, especially when you could see that stock dropping down to the low single digits. Then again, it's a great company, and as soon as the employment rate picks up again and wages start rising, people will probably go back to their old coffee and latte habits. So, you decide to play it both ways. You refuse to buy the stock if it's dropping from here. But, if it rises to a certain target point, you buy it automatically. The stock has to show you it has legs first, in other words, and only then will you buy it. Won't you end up paying more that way? Yes. If you enter a buy-stop @12 on SBUX, you will end up paying $12 if the stock rises to that point. On the other hand, if the stock drops quickly to $2 or $3 from here, you won't touch it. This example isn't just academic for me. I help a good friend manage his IRA. He's normally very sensible, but when he saw SBUX trading in the high teens a few months ago he was convinced he needed to buy it. I was convinced that Starbucks was entering a period of scary pain that would last at least 3 - 5 years, possibly ending in bankruptcy. With the stock at $17, I didn't recommend buying it at all, but I could only get him to compromise on placing a buy-stop @20. If the stock had risen from there, he would have bought it. Of course, we just saw that the stock has dropped to the $9 range and may well drop further. The buy-stop @20 never executed and then dropped off after 6 months. Thank God for buy-stop orders. They put the investor in a position to buy stocks that are rising in value, avoiding stocks that are dropping in value. If, on the other hand, you place a buy-limit order, you will buy the stock only if and only as it is dropping. Kind of a dangerous game if you think about it, like trying to catch a falling knife.