Try limit orders to tame stock trading risk

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If you took an item marked $5 from a supermarket shelf, and when you went to pay, the cashier said it’s now priced $10, you’d probably demand to see the manager. But a similar scenario can occur when you’re buying shares of stock.

The market moves with the buying and selling of many investors and trading firms. Within the minute it may take to check a stock price online and then call your broker with an order, the share cost could have moved up or down.

But more recently, incidents of wild market movements have been attributed to computer-driven trading glitches. The “flash crash” in May 2010 and the program-trading error involving Knight Capital Group, which disrupted pricing on some 140 stocks Aug. 1 this year, are two of the better-known anomalies.

These events only add to investors’ fears, already stoked by the economic downturn. “People are wondering, ‘What is going on here?'” says George Padula, a financial planning instructor at Boston University.

Outside of trading glitches, extreme volatility, whereby the Dow Jones industrial average swings more than 100 points in a day, has been on the rise, Padula says.

Fortunately, brokerage firms offer tools known as “limit orders,” allowing investors to specify a price point to buy or sell. “In our investor education, we have talked about using limit orders, so you can control the situation more,” says JJ Kinahan, chief derivatives strategist with TD Ameritrade.

Many firms don’t charge any additional commission to use limit orders. They can be applied to transactions involving exchange-traded funds or stocks, but not mutual funds since the share price of mutual funds typically changes just once per day, Padula says. Investors can specify if they want the order to last just one day or are “good ’til canceled,” meaning the brokerage firm will keep it open for a longer period such as 30 to 90 days.

Here’s a primer on limit orders and related tools that give investors more price certainty.

Buy and sell stock with limit orders

How they work: Distinct from a “market order,” whereby you ask a broker or go online through a discount brokerage to buy or sell shares at whatever the current price may be, a limit order allows you to specify the price at which you’ll buy or sell. For instance, if you see that XYZ stock is trading at $40.20 a share and you’d like to sell at $43 per share, you’d enter that limit order.

Anytime a particular stock trades at a relatively low volume, setting a limit order guarantees you don’t buy above or sell below your specified price, says Erika Safran, founder of Safran Wealth Advisors LLC in New York. And even with high-volume trading stocks, if you’re determined to execute your order at a certain price, limit orders are essential.

The downsides and benefits: Anytime you place a limit order, there’s no guarantee that the market price will move to that exact point and the transaction will actually go. Using limit orders means you are buying at the price you want. “They are good for (the stocks) you desire but don’t feel you have to have,” Kinahan says.

Padula says limit orders can impose discipline on investors who are overeager to take a quick profit or to buy a stock. For instance, if you see a stock you bought quickly climbing up in price, instead of taking an instant profit, you may set a limit at a target that you believe will eventually be met.

The caveat is that investors must have a well-thought-out strategy on why they want to sell at a particular price. Investors can be excited at setting a sell target that leads to a satisfying profit, Padula says, but then they may be left with cash “where they don’t have any good options on what to invest in again,” he says.

Padula advocates looking at your entire portfolio and selling a stock not just to make a profit, but to allot to another promising investment that fits in well with your overall asset allocation plan.

Stop-loss and stop-limit orders

How they work: Anyone who’s been investing for a few years probably has kicked themselves for holding a stock even as conditions caused it to spiral downward.

The “stop-loss order” is meant to prevent holding on to a loser, allowing an investor to set a point whereby if a stock slides to that price or below it, it triggers a sale, limiting a loss or protecting a profit on a stock. But the price that you’ll sell at with a stop-loss order isn’t guaranteed. The sale could go through at a lower price.

A “stop-limit order” works similarly, except that the sale won’t go through unless the stock can be sold at the exact limit price.

For instance, if an investor puts a stop-loss order in on ABC Co. stock at $50, when the price slips to or below that $50, a sale is triggered. If the investor instead places a stop-limit order at $50, the order goes through if the price hits $50. But if the stock never trades at the $50 level and continues spiraling downward, the shares aren’t sold. So there’s no guarantee with a stop-limit order, either.

The downsides and benefits: Because the market has been very volatile, with big drops followed the next day with a similarly large gain, Safran is hesitant about advising investors to establish either a stop-loss or a stop-limit order. “You could trigger a sell when the (stock) drops 20 percent, for instance, and it might rebound,” she says.

For those who may not follow stock movements closely on a daily basis, a better way to keep informed about when a stock may be dropping consistently is to establish alerts, Safran says. Brokerages commonly allow their customers to establish email or text alerts anytime a stock reaches a certain level, either up or down from where it currently sits.

“You could set up an alert at a price that’s 20 percent lower. You could then investigate what is really happening to the market on that stock and then decide what to do,” she says.