For example, if you bought a stock at $10 that's now trading at $20 and you want to "protect" some of your gains, you can place a sell stop order with your broker at say $18. If the stock price drops to $18, a simple sell stop order will trigger an immediate market sale, which means you'll get the price of the next available shares. It should be noted that a simple sell stop order does not guarantee a price of $18 on your sale, but it does guarantee execution.
When triggered, a stop order becomes a market order.
Many Fool advisers and long-time Fools preach against these. In setting automated actions based on pricing, the long-term investor is allowing the market to dictate the price at which one winds up selling. Many times, corporate events pop up and surprise the market and kick people out of long-term positions based on their stop orders.
Market volatility will often trigger a stop order soon after it is placed. In an age of discount broker commissions, repurchasing the position after a false sale event is not costly, but the Wash Sale Rule can be a limit in the case of a loss. To avoid premature triggers, an email or text alerting service can be preferable--allowing you a decision on whether to sell or wait out the even.
Also, for stop losses, many investors operate under a misconception that they'll save themselves from significant stock drops. But if you have a stop order at $15 for a stock that closed yesterday at $20, reports bad news, and opens at $12 -- you will sell at $12, not at $15.
Just know that if you're going to use stop orders, you are taking your own decision-making out of the game and setting an automated direction based on ephemeral -- sometimes irrational -- price movements.
Related Premium Service Links
- Here is a very good explanation of why TMFBreakerRob never uses these (a link for Motley Fool Rule Breakers members)
Recent Mentions on Fool.com
- 5 Lessons From the Wright Brothers on How to Be Successful in Life
- How Masayoshi Son Built and Then Rebuilt His Billion Dollar Empire
- Here's What's Behind TASER International's Latest Acquisition
- Flowers Foods Earnings Fall Flat, but Rising Results Could Be on the Way
- 3 Reasons Microsoft Corp. Should Buy BlackBerry Ltd.
- 3 Things Investors Should Know About Business Infrastructure Solutions