Stop Order 

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Stop Order

A stop order is an instruction to buy or sell a stock whenever the stock trades at or past a specified price, when it then becomes a market order. You can use a stop order to protect existing profits or reduce losses. Although a stop order might appear similar to a limit order, they have some differences.

A stop order differs from a limit order in that after the stock’s price reaches the stop-order price, the stop order becomes a market order. Suppose that you buy some stock at $20 per share that is now trading at $30 per share. Selling those shares would result in a $10 per share profit. To protect this profit from a rapid price drop, you can place a stop order to sell at $28 per share. If the stock drops to $28, the stop order then becomes a market order and is executed at the prevailing market price. If the stock is sold at $27.75 per share, you have protected a profit of $7.75 per share. On the other hand, if the stock keeps increasing from $30 per share after the stop order is placed, the stop order lies dormant (if it has no time limit and is a GTC order) until the share price falls to $28.

Similarly, you can protect profits on a short sale by using a stop order to buy.

In addition to protecting profits, stop orders can be used to reduce or prevent losses. Suppose that you buy a stock at $10 in anticipation of a price increase. Soon after your purchase, news from the company suggests that the price may go down rapidly. You can place a stop order to sell at $9, which limits your loss if the stock price declines below $9 per share. Limiting losses on a short sale is the other use for stop orders.

Another danger awaits when you are setting a stop-order price. If you place the stop-order price too close to the current price, a temporary surge or fall in price of the stock can trigger execution of a market order. Then, although the stock price might move back in the direction you anticipate, you no longer have a position in that stock. On the other hand, if the stop-order price is set further away from the current market price, less profit is protected (or you risk a greater loss).

Of course, the use of stop orders does not increase profits if you do not correctly anticipate the direction of the market price.

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