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
- 3 Things Intuitive Surgical, Inc. Management Wants You to Know
- Zimmer Holdings, Inc. Stays Ahead with a Healthy Third Quarter
- 5 Things Philip Morris International's Management Wants You to Know
- Can Ads And Cable TV Get the WWE Network Off the Mat?
- FMC Technologies Boosts Its Profits, But Investors Still Want More
- 3D Printing Stocks: A Deep Dive Into Arcam AB's Winning Q3 Earnings Report