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Using limit and stop sell orders for stocks

Submitted by root on Wed, 03/23/2016 - 10:31

If it is May 1st and I have $1000 to invest, and after due diligence, I like a stock which sells for $99, I might buy 10 of them at the market price and pay $10 for the commission. Assuming the stock has good volume and I end up getting it for $99, I will end up with stock worth a total of $990. (This technique will not work for stocks which do not have good volume because the actual sale price will be very different from the market price. I am not a sophisticated investor so I stick with stocks with large volume.)

Because of human psychology, I now face two risks:

  • Greed: if my stock rises to, say, $110, I might convince myself to wait just a little longer to make as much money as possible.
  • The sunk cost fallacy: if my stock falls to, say, $90, I might convince myself to hold on because I'd lose too much if I sell.

In both cases, I'd be wrong and that's that's why most investors lose money.

To reduce these risks, once I own the stock, I will immediately decide my target price and tolerance for potential loss; and I would like to place the following orders which are good for 30 days:

  • A sell order of type stop at $90. This will guarantee that I cut my losses and the stock will be sold if it falls below $90.
  • A sell order of type limit at $110. This will insure me against greed and guarantee that the stock will be sold if rises above $110.

Certain brokerages do not allow these so-called "one-cancels-the-other" or "bracket" orders. Scotia iTrade does not allow them, but Questrade seems to. See also this StackExchange thread.

If I check my portfolio every month, then on June 1st one of these scenarios will have played out:

  • The stock has lost value and triggered the sell order of type stop, in which case I'll wind up with $890 after my sell commission.
  • The stock has gained value and triggered the sell order of type limit, in which case I'll wind up with $1090 after my sell commission.
  • The stock hasn't moved too much, in which case I can decide whether to get rid fo the stock in favor of another one, or to keep it. If I keep it, I'll then place two more stop and limit sell orders good for another month.

More about order types can be found on the YouTube video "FRM: Order Types (market, limit, stop, stop-limit)".