FEDweek

Setting Limits on Potential Losses

When you buy or sell stocks through a broker, there are two types of orders you can place: A market order obligates you to buy or sell at the current trading price. A limit order puts a cap or a floor on your trading price.

Savvy investors may prefer to use limit orders. Suppose, for example, you like a company’s prospects but you think the current $100 trading price is too high. You could enter a limit order at, say, $90 or $80. If the stock falls to that price, you’ll buy it. Thus, if you can be patient, a limit order may allow you to purchase that stock at a favorable price.

Limit orders also can be used on the sell side. You might, for example, set target prices for stocks you own, placing limit orders to get out at those prices. At the same time, you can place stop-loss orders. Say you buy a stock for $80; you might want to enter a stop-loss order at $70, to limit your downside in the stock. Many investors are reluctant to take losses so using stop-loss orders can be an effective way of removing emotional barriers. You can sell, take a tax loss, and reinvest in another stock that may offer better prospects.

One strategy is to raise your stop-loss order if the stock moves up. Suppose, for example, that $80 stock mentioned above goes up to $100. You might raise your stop-loss from $70 to $90, to lock in a gain from your original $80 purchase price. If the stock keeps moving up, you can keep moving up your stop-loss order.

If you use limit orders, don’t forget about them. Say you buy a stock at $80 and have a $120 price target so you place an order to sell at $120. The stock goes nowhere so you decide to sell your shares. Unless you cancel your order to sell at $120, that order may remain on the books. If the stock moves up to $120 one day your broker may enter your sell order, which would be a short sale, a risky strategy that may prove to be very costly.