To mitigate such type of risks, you could put a stop-loss order, wherein you ask your broker to sell the stock once the price falls to a certain level, known as the stop price, say Rs 255, in this case.
When you place an order for a dosa in a restaurant, the waiter asks how you want your dosa—plain, masala or crispy. Similarly, you have several options for ordering shares in the stock market. Knowing the differences among different type of orders can often help you to get the best price when you buy shares and avoid losses.
Market order is nothing, but you want the order to be executed at the quickest as possible. Market order could be either to buy shares (buy orders) or sell shares (sell orders). In both cases, you simply trading the shares at the current market price. For instance, if ABC share is selling at Rs 250 a share, a market order will most likely get you the required shares around Rs 250 most of the time.
Stop loss order
This is an interesting tool which investors can use to limit their losses in a market rout. For instance, if you had bought 100 shares of ABC Ltd at Rs 250 and it rises to Rs 265, you are looking at a gain of Rs 1,500. But you are worried that if the market falls, you could lose the entire gain of Rs 1,500 and even more. To mitigate such type of risks, you could put a stop-loss order, wherein you ask your broker to sell the stock once the price falls to a certain level, known as the stop price, say Rs 255, in this case. So, at this juncture, your stop-loss order become a market order, and you will sell at the next available price at Rs 255. In this case, probably you would lose your gain but definitely not your capital.
Trailing stop order
A slight variation of stop loss is called trailing stop order wherein the sell order will trigger if share price falls below a certain percentage. For instance, if ABC’s share is trading at Rs 250, you could place an order to sell if the share price falls 10% to Rs 225. If ABC’s share price rises to Rs 260, your trailing stop would still be 10%, but the selling price would rise to Rs 234.
The issue with market order and stop loss order is that sometime share prices could move significantly between your order time and the time the trade is executed. To overcome this risk, the concept of limit order comes into picture. A limit order allows you to specify the maximum or desired price at which you will buy a share and the minimum price at which you like to sell. But, please note that your order will not be executed unless that price becomes available.
Stop limit order
This combines the protections of a stop loss order and a limit order. With a stop limit order, you can specify a point at which you would like to sell—the stop—as well as the lowest price below the stop that you will accept. For instance, if you have a stop-loss order at Rs 255 for ABC shares, you could add a limit of Rs 253. This means you would take any price from Rs 253-Rs 255. If the stock goes below that range, you will have to hold until the price hits Rs 253. Broking firms charge the same amount as commission irrespective of your order types. All types of orders have time, and most are day orders which means that they are good only for the day you place your order.
To conclude, for majority of the long-term investors in a reasonably calm market, a market order is fine. But, stop orders can trim your losses especially when the market is in a downturn and using the limit order to buy can help you grab the bargains when the market has sold off.
(The writer is a professor of finance & accounting, IIM Tiruchirappalli. Views are personal)