U.S. Markets closed

How Stop Orders Can Help You Limit Losses And Buy Correctly

You buy a stock as it breaks out in strong . All is well as you head out for your dentist appointment or a weeklong cruise.

Then the CEO suddenly resigns, and the stock plunges. You would have sold when the stock fell 8% below its , triggering the golden rule. But you miss that opportunity; it's now down a lot more.

Investors with little time to monitor their stocks can miss an event that can derail a top growth stock that looked great minutes ago. Such investors should consider using sell-stop orders to preserve gains and limit losses.

A sell-stop order tells your broker to sell a specified number of shares when the stock falls to a certain price. In effect, you're stopping your losses at that point.

Another option is a sell-stop limit order, which tells the broker to sell at that price or higher.

In many cases, sell-stop orders can protect you from bigger losses. However, there's no guarantee that the broker will be able to execute the order at the exact stop price. That could pose a problem in some cases, as Fossil (FOSL) showed last year.

The watchmaker and apparel boutique chain broke out above a 110.84 buy point from an unusual cup base in February last year. Because IBD-style investors know to cut their losses at 8%, you could set a stop-loss sell order 8% below the buy point, at 101.97.

Over the next 11 weeks, the stock ran up to a high of 139.20 on April 5, good for a profit of 26%. It's normally best to take at least some profits after a 20% gain.

Then the bottom fell out. Fossil gapped down on May 8, opening at 92.10, far below the previous day's close of 125.77, after a disappointing quarterly report. The drop would have triggered a regular sell-stop order, which the broker would dutifully execute at the first possible opportunity, resulting in a massive loss.

To be sure, a gap down is the nightmare scenario because it happens so quickly. There's not much you can do to avoid losses even if you place a market order.

But, in this case, a stop-loss limit order would have at least offered the opportunity to recover some of the losses. That's because the gap down would have prevented the broker from selling the stock at or below the designated sell price. You would have had the option to dump your shares at the market price or hang on and hope for a rebound.

Today, 10 months later, Fossil has rebounded to as high as 115.

Buy-stop and buy-stop limit orders work in a similar way to their sell-side counterparts.

Let's say a stock has shaped a nice cup-with-handle base and is nearing its buy point. You can set a buy-stop market order at the buy point. If the stock hits that point, the buy-stop order will tell your broker to execute a market order at the best available price.

Sometimes, though, the stock gaps up well above the proper entry. If you set a regular stop order, you would be filled at the . But a buy-stop limit triggers an order to buy at a set price or better, once the target price has been reached.

For example, you could set a buy-stop limit order at 25 with a limit price of 26. Once the stock passes 25, the broker will execute the order as long as the price remains below 26.

Buy-stop orders don't take volume changes into account. So if your stock breaks out in weak volume, the order will be triggered anyway. If the action is poor, you can sell the stock right away or see if volume picks up later.