People complicate investing with various concepts, philosophies and principals. There’s diversification, dollar cost averaging, P/E ratios, yield, growth vs. value, sector rotation, and on and on. But when you strip away all of these layers of complexity, you are left with one cardinal principal of successful investing:
Buy low, sell high.
It’s really that simple when you get down to it. You can follow all the other practices and techniques, but for the most part you don’t make a profit if you don’t sell for more than you buy. Yes, I know there are ways to make a profit when stocks fall, but this is more about the simple and straightforward investor.
Before I move any further, I want to be clear about one thing: What I am about to discuss is primarily for the small investor, and should not be considered for your retirement savings (401(k), IRA, etc..). For those, you should stick to tried and true sector/capitalization diversification, or maybe go with a super-simple portfolio. This is about how to buy low and sell high when trading stocks, not investing for retirement. Now, without further ado, on with the post…
I know, it sounds trite and perhaps a bit condescending to say “buy low and sell high”, but it is often taken for granted. In other cases it can be misconstrued to support market timing, which rarely succeeds over extended periods of time.
I’ve heard buy low sell high sometimes referred to as “buy high and sell higher”, and that’s ok too because it’s the profit we’re after in the end. We don’t want to be concerned with finding the bottom price of a stock per se, just a price that’s lower today than it will be in the future.
The trick of course is knowing when to buy and when to sell a given stock. There’s a Kenny Rogers quote in here somewhere, but I’m going to resist making it. You can thank me later.
As I was saying, this is where many people get into market timing and trying to guess when a stock is at its peak price and they should sell, or conversely when a stock can go no lower and it’s safe to buy. Timing the market is notoriously difficult to do successfully. This is one of the reasons most day traders never become wealthy (fees and commissions on excessive trades is another).
So, if you can’t time the market, how then can you be sure to buy low and sell high?
Well, you can’t be sure. Nothing in the stock market is a sure thing, but there are a few tools you can use to help increase your chances. Actually there are two basic tools, and they exist to help the investor minimize loss and maximize gain. They are the Limit Order and the Stop Order.
Market Orders
To understand a stop order it is first necessary to understand how shares of a stock are purchased normally.
When an investor buys x shares of ABC corp stock, it is executed as a market order (unless otherwise stated). A market order is simply a request to purchase (or sell) shares of a stock at the going price at the time at which the order is processed. It’s that last bit that can get dicey. For instance, you may place an order to purchase stock when you see that the price has fallen to what you consider affordable and close to intrinsic value, but by the time your brokerage firm executes the order the price may have already jumped 5%, thus making you late to the party and missing the boat on that 5% profit. It should be noted that in today’s market where orders are processed much more efficiently and by computer instead of a human, the price differences tend to be less for highly traded stocks. However, for smaller stocks the price fluctuation can still be quite large.
Ok, so that’s the general concept of a standard purchase order. Now on to a Stop Order.
Stop Orders
As an investor, you can’t control when a market order is executed, but you can dictate the price at which the order should be executed.
A stop order is essentially a market order that can only be executed after the share price has passed a specified threshold, as set by the investor.
For example, say you are interested in buying x number of shares of HotStock Inc. It currently trades at $20 per share, but you think it would be a bargain at $15. You would place a stop order for x shares of HotStock Inc at $15 per share. The means that once the share price dropped to $15, your stop order would become a market order and you would buy x shares of HotStock Inc at the current market price.
Conversely, say you already own x shares of HotStock Inc. suppose you bought them at $15 per share and the price is currently $25 per share. You might not want to watch HotStock Inc every minute of the day, but you want to ensure you get some profit on your smart stock pick. You would set a stop order at $20 per share. That way if the price dropped to $20 per share, you would sell your stock, making a $5 per share profit. This is also known as a Stop-loss order, because you are (in theory) stopping your losses before they get too large.
But what happens if the price dropped from $23 per share to $9 per share before your order was executed? In short, it sucks to be you. Your $5 per share profit just became a $6 per share loss. And in the example of using a stop order to buy x shares of HotStock Inc at $15 per share… you could end up buying it on its way to the basement.
This is where Limit Orders come into play.
Limit Orders
A limit order is essentially a stop order with an additional price limit specified by the investor. This additional limit is the price at which the order will be canceled, thus giving additional control and protection over stop loss orders. You can effectively bracket your target price with upper and lower trigger points.
For example, if you want to buy x shares of HotStock Inc. stock, but only if it falls below $15 but not less than $13 per share, then you would place a limit order for x shares at the price of $15 with a limit of $13. If the stock falls below $15 per share, then your order becomes active, but if the price falls to $9 before the order is executed then it will be canceled and no purchase is made. Of course, if the price hovers at $14 and then drops to $9 after you purchased it, you are still at a loss.
You may be wondering if this technique is really that helpful when buying on the upside. After all, what if you set a price of $15 per share on a small company that is not traded heavily and the price has jumped to $25 before your order is executed? You would have bought high and paid much more than you intended. This is where a Stop-Limit Order comes into play.
This is a limit order that has a trigger point (just as any limit order) but also an upper limit at which the order becomes nullified. Think of it as a sort of kill switch. For instance, say you are a momentum investor and want to buy a stock only after it has shown some renewed signs of life. You want to buy x shares of HotStock Inc. stock if the price goes above $15 per share, but less than $17 per share. This way if the stock price has jumped to $25 before your order is placed, your order has been canceled and won’t be placed.
Final Thoughts
Stop and Limit orders are not a magic bullet. They will not make you a successful investor on their own – you still need to do your homework. For instance, you can still guess wrong when determining where to put your stops and limits. Cheap and expensive are subjective terms, and subject to error. But the point is that it does give you some control over what you pay for a stock and how much you will sell shares for. The rest is up to you.
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