Stop-market orders are very, very similar to limit orders—so similar, in fact, that many investors have trouble telling them apart. The difference is that they’re used to cut losses, as opposed to maximizing profits.
Like limit orders, stop-market orders (sometimes called stop-loss orders) cause a stock to be bought or sold automatically upon reaching a given threshold. When this happens, they turn into standard market orders and execute at the going market rate. The goal: damage control, pure and simple.
Suppose you buy a stock at $35, and it starts to tank. You can execute a stop-market order at $30 to cut your losses. This means that if the stock falls past that threshold, it’s as though you suddenly placed a sell market order. The final sell price may be $29.50, or it may be $31, but in either case, you’ll have reduced the effects of the sudden dip.
Conversely, if you’re interested in another stock trading at, say, $40 and are waiting for it to drop, but you don’t want it to get away from you, you can execute a stop-market order at $42. If the price shoots up, you might end up paying $42.50, or perhaps $39, but you’ll have achieved your end of minimizing your losses in purchasing a security that you’re especially hot to get hold of.
Stop-loss orders are useful, but be careful. A sudden rumor, or a rapid but temporary drop in the stock price, can cause you to get frozen out of a stock against your will.
Stop-limit orders are stop-market orders’ identical twins—with one difference: when the threshold price is reached, the order changes into a limit order, not a market order.
Why does this matter? Because in theory, the stop-limit order gives you much more control over the actual price at which the stock is bought or sold. When you place the order, you have to specify both a sell price and a limit price, and the combination helps to eliminate the wild-card factor that creeps in with stop-market orders. The drawback, of course, is that as with all limit orders, the trade may not get executed at all.
Consider the following situation. You’ve got your eyes on a stock currently trading at $25. It starts to show some upward momentum, so you place an order with stop and limit prices of $22 and $23, respectively. Once the stock rises above $22, the limit order kicks in. However, if the stop gaps above $23 due to a fast-moving market, the order will remain unfilled.
Trailing-stop orders are yet another variation on the stop-market theme. Here the difference lies in the fact that instead of setting an absolute threshold, you set an order to buy or sell if the stock rises by a certain percentage (or, in some cases, a specified dollar amount). Other than that, all the same rules apply as with other stop orders.
Trailing-stop orders seem to provide some folks with a sense of security. There are traders who set 20% trailing stops on every order they place. Remember, though, that like all stop orders, the brokerage fees are higher than with market orders, so you need to ask yourself if that psychological advantage is worth it.