Wednesday, March 31, 2010

Stops, Limits, and Other Things Students Hate

A Series 65 customer just sent me a question by email:

Thanks for the tutoring on Saturday!! I am still a little unsure about the whole stop order and stop limit order. When do you want to use these ? Also does one make a bear market worse or a bull market better.. Also with the short sale... Are a lot of these a sign of a bull market...?

The following is my response to her inquiry:
Hi, Nicole

First, separate the sell limit order from the stop order. A sell limit order is placed at a price higher than the current market. Let's say the bid on ABC is $50, but you don't want to sell your ABC for anything less than $52. Place a sell-limit at $52. If the bid rises to $52, your stock is sold. If not, you keep holding. So there's no protection here. If the stock drops, it keeps dropping. You just want to sell it for a specific price or better/higher. The stock has to go up before it can be sold.

To protect your downside, place a sell-stop order. If you're holding ABC and the market price is $50, you could protect your downside by placing a sell-stop at, say, $49. If the stock stays above $49, you hold it. If it drops to $49 or lower, it is sold automatically. Notice how your upside is still wide open--you only sell to protect against a loss. That's why the order is also called a "stop loss" order. These can make a bear market worse because if the stock drops a little, a bunch of sell orders go off at the same time on autopilot.

If you turn this order into a sell-stop @49, limit 49, you no longer have protection. Why not? If the stock opens in the morning at $48.50, your order would be activated, but you're saying you won't accept one penny under $49. If the stock keeps dropping, the broker-dealer won't be able to sell it for you . . . not unless or until the stock makes it to $49 or higher.
So, to protect the position, enter just a sell-stop . . . don't add the word "limit." whenever the order has a " limit " price, it can only be executed at that price or better.

On a completely different note, a high level of "short interest" on a stock could be a BULLish indicator. If a big % of a company's stock has been sold short, it will also have to be bought back by the short sellers . . . that buying pressure could--maybe--raise the price of the stock. That's how technical analysts think--has nothing to do with the underlying company; it's based entirely on stock market data.

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