How to Lock in Profits and Limit Losses

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Today's stock market is not like the market of the good old days. In the 90s, you would put your money in the market and just watch it grow. Not so any longer. Over the last ten years, the S&P 500 is essentially flat.

Today, you have to fight for every percent, and using the appropriate buy or sell order will help you do just that. Let's take a look at the various types of stock orders, and when it's best to use each one.

1. Market order. The standard, default order is called a market order. This simply means that your trade will be executed at the current market price. Market orders are generally executed immediately at the best price offered by a market maker, a firm that is quoting a buy a sell price for stock. The market maker is required to offer shares for purchase and sale at a price of its choosing. For investors buying large blocks of shares, it is important to note that a market maker guarantees to buy or sell only a certain number of shares at a set price (this could be anywhere between 100 and 5,000 shares).

A market order to buy or sell is an instruction to your broker to transact at the prevailing price at the time of execution. For small caps with low volatility, the market order is an easy one to place. However, with more volatile stocks, you might get some unexpected surprises upon execution. Use market orders if you must buy or sell a stock immediately and the execution of the trade is more important to you than the price of the transaction. This can be important when you're trying to buy a stock that is running higher and are confident that you need to own the stock, even if the trade execution may be at a higher price. Likewise, if a stock is falling quickly due to bad news, use of a market sell order to exit a position can be prudent.

But in most circumstances, using market orders is not advisable, since the price of a small-cap stock tends to be more volatile than their large-cap cousins, primarily due to lower liquidity. Instead, I recommend using limit orders (see below) to narrow down the specific trade you would like, and at an exact price. While these trades don't get executed as quickly as a market order, you'll have the assurance that the trade will be made at your desired price (if it is executed).

2. Limit orders. When you place a limit order, you state the exact price at which you want to make a purchase or sale. The order will only be placed if that price is available. This is a smart way to buy and sell small caps, because you set and control the price; if the market price varies from that level, the buy or sell order will not go through. However, limit orders are not effective if you want to make the trade immediately , since the trade may not be executed.

3. At or better. This is a variation on limit orders. In the usual limit order, the trade is triggered once the specified price is reached, even though the actual trade value may be higher or lower. This varies by brokers' definitions of the limit itself. Some traders use at or better as part of the order. Thus, a buy order will be executed at or below the limit price, and sell orders will be executed at or above the limit price.

4. Stop loss. As the name suggests, the stop-loss order is used to limit losses. This order includes a price trigger that generates a sell if the stock falls to a specified price level. When shares fall to the prescribed price, a market order to sell the stock is executed. This may mean that the trade is executed at the stop-loss price, or below that price in a fast moving market. This is a wise form of protection when you are in a highly volatile market, and especially if the market risk and volatility levels for your stock are higher than average. You pick the stop-loss price knowing that the stock is going to be sold when that price is triggered. This order is best used to protect downside exposure by limiting potential losses from your stocks. With small caps, you must be careful, as the volatility could "stop out" a position based on intra-day volatility. Therefore, use these cautiously, and set them at a price at which you'll definitely want to sell the stock. For hands-on investors watching the market, stop losses are less useful, since you're always watching your positions.

5. Trailing stops. A useful variation on the stop-loss order is the trailing stop. In this situation, you are preserving paper profits rather than limiting losses. In cases where your small-cap stock has appreciated, a trailing stop is a smart order to have in place. The order represents a fixed percentage of the current market price. If the price falls by that percentage or more, the trailing stop becomes a market order and a sell is placed. But if the stock's price continues on its upward rise, the trailing stop continues in force without any action. It only goes into effect if the price falls from a high point to the percentage set in your standing order. Like the risks of a stop loss, this can cause problems for small-cap investors. If a stock rises quickly, and then falls back from a high price, the shares would be sold using a trailing stop. The concern here is that your broker could automatically sell a stock you wish to continue owning.

***My book, The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks, is filled with every tip and trick I know about investing in small-caps, and I think it's absolutely vital to anyone interested in the topic. There is a ton of great information in the book, and it is a great compliment to Small Cap Investor PRO .

I'd like to give you a free hardback copy when you join Small Cap Investor PRO . Click here to get the full details.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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