People are often confused by the difference between sell-stop and sell-limit orders. And, for some reason, some exam candidates actually start to confuse stop and limit orders with options, which would be sort of like confusing an airplane with a cheeseburger.
Options are derivative securities. When we discuss “stop” and “limit” orders, we’re talking about a method of buying and selling. Stop and limit orders can be used to buy and sell stock or options, but they are not investments, remember. They are types of orders. The easiest way to place an order to buy or sell stock is a “market order.” There is a market price for the security; a market order gets filled at the best price the market will currently bear. So, if the exam question says that the customer primarily wants his order to be filled, choose the market order. It will be filled as fast as possible at the best price currently available. Stop and limit orders are specialized. The customer names a price at which something needs to happen. If the stock never reaches that price, nothing happens. For example, let’s say you bought 1,000 shares of ABC common stock @20 back in 1998. Today the stock trades for $48, and you see from your notes that your target price was $50 for that stock back when you bought it. It’s only $2 away from the target you had for selling, so you can enter a sell-limit order @50. You will not accept one penny less than $50 a share, but if somebody is willing to pay $50 or more, you will sell automatically. Notice how the stock price has to rise for the sell-limit order to execute. What if the price does not rise? Nothing happens to your stock. If you had marked the sell-limit order “good for the day,” it would go away. If you had marked it “good ’til canceled” or “GTC,” the order would remain on the books. What if the stock had dropped? It would have dropped. A sell-limit order is placed above the current market price and, therefore, only goes off if the stock rises. If the stock drops, the investor wishes he would have placed a sell-stop order, instead. Why? A sell-stop order provides protection. With the stock sitting at $48, you were sitting on a potential capital gain of $28 per share. If you had wanted to protect that paper gain, you could have placed a sell-stop order @45. At that point if ABC had dropped to $45 or lower, your shares would have been sold automatically to protect most of your gain on the stock. If the stock had risen or at least stayed above $45, you would have continued to hold it. See the big differences between the sell-limit and the sell-stop order? If the investor uses a sell-limit order, she really wants to sell her stock. She just wants a few dollars more. Unfortunately, she gets no protection against a drop in price. On the other hand, if the investor uses a sell-stop order, she does not necessarily want to sell. What she wants is to have her cake and eat it, too. She wants to hold the stock as long as it cooperates, but she wants it sold automatically at the first sign of trouble.
Sell-limits are placed above the current market price for the stock. Sell-stops are placed below the current market price for the stock. What about buy-limits and buy-stops? Let’s save that excitement for another post. It’s barely 7 AM on a cold Wednesday morning in Chicago. I don’t want to overdo it.