Automatic Orders

Here's a practice question appropriate for today's scary movement in the secondary markets:

A large number of which of the following orders could exaggerate a market drop, sending the DJIA down nearly 1,000 points in a half hour?
A. sell-limit orders
B. sell-stop orders
C. buy-stop orders
D. market not held orders

EXPLANATION: you can eliminate any choice with the word "buy" in it, since buyers don't cause the price of things to drop. The "market not held orders" choice doesn't really tell you enough--that could be a buy or a sell. Somebody's just trying to throw you off. So, you can quickly eliminate two answer choices. But, then, many candidates become confused between the sell-limit and the sell-stop. The key is this--where is the sell order placed in relation to the current market price for the stock? The sell-limit order is placed above/higher than the current market price, so those sales only go off if the price rises. Sell-stop orders, on the other hand, go off when the stock price drops--see the problem? Market price drops a bit, a bunch of sell orders go off at the same time, sending the price down some more, setting off more sell-stop orders. The news media usually refer to these orders as "program trading," but the exam would probably call them sell-stop or "stop loss" orders. They are placed below the current market price, usually to protect a long position in the stock. Trouble is, if too many people use these orders on the same stocks at the same time, a bear market can get even scarier. Oh well. Just one more testable point to keep track of. Eleven thousand seven hundred fifty-three to go.
ANSWER: b

More from the Margin Front

Well, things in the old margin account have certainly gotten interesting. Hospira, which I plan to sell in order to pay down the "debit balance," is doing okay--in fact, it's worth about $3,600, which is enough to pay down the initial loan. But, well, things got a little complicated. I had inherited 200 shares of FMBI, which is a bank holding company. Why did my 70-year-old mother hold shares of a bank holding company headquartered in Itasca, IL? Apparently, her father--my Grandpa Olson--was a founder of the Farmer's Bank of Wyanet, which was purchased by FMBI along with about a dozen other small Illinois banks. Why Mom had never mentioned any of this--who knows. In any case, the stock had been devastated, along with all other financial/bank stocks, and I was not willing to watch it drop to zero. So, I placed a sell-stop at $5.99. As you know, that meant that if the stock dropped to $5.99 or lower, it would be sold.
It did, and it was.
Well, I suffered the usual seller's remorse and started to worry that the stock would eventually rise without me. So, I placed a buy-stop on 100 FMBI at $10. As you know, that meant that if the stock rose to $10 or higher, it would be purchased.
It did, and it was.
This being a margin account, $1,000 of stock (plus a $9.99 commission) was purchased and placed on my tab, a tab which is now $4,557.78.
Hmm. I should probably place a sell-stop on HSP right now. That way if it plummets, I won't lose my best chance to pay off most of this silly margin loan.
I don't know. Every sell-stop I enter seems to be sold a few days later, at--by definition--a lower market price.
Oh well. Nobody forced me into this loan, and it isn't like I owe Tony Soprano. The interest rate is right around prime, and is tax deductible, unlike the juice I would have to pay to Mr. Soprano. I'll survive. I just want to win this one, even though I know how quickly I could end up losing.

On the Margin Trail

Hospira has advanced since I last reported, but is still down 11% from my purchase point. If the stock rises $3 a share, I'll be tempted to sell it, pay off the margin loan, and be done with it. But, if that happens, I would probably instead just place a sell-stop order slightly below the market price. In other words, if it rises to $40, I'll place a sell-stop at $38.50. That way if the stock stays above $38.50, I hold it; if it drops, it's liquidated. What I won't do is let the stock go up to $40 and then plummet with me still holding it like a total loser.
On the other hand, what if Hospira (HSP) drops from here? Then, I move on to Plan B, which is to take a loss, throw some cash money on the table and walk away from this crazy idea of borrowing money backed up with stock as "collateral."

On another note, the 200 shares of FMBI that I inherited a few years ago were triggered and sold at $5.99 when my sell-stop was activated. But, now that the big banks are reporting positive earnings, little bank holding companies like this one are starting to rise again. Unwilling to jump in just now, I placed a buy-stop-limit order for 100 shares FMBI, with an activation price of $10 and a limit price of $10.50. What if the stock drops from here? I'll be glad I never bought it. But if it rises to $10 or more, I'll end up with 100 shares.

Again, the idea that "this Series 7 stuff has nothing to do with the real world" is crazy. I'm using sell-stops, buy-stop-limits, and margin loans in my daily life. And pretty soon so will many of you.

Careful out there.

Stop, Limit, and Market Orders

Let's look at a question on stop, limit, and market orders. Try to use process of elimination until you find a strategy that works for the following pretend customer:

Your customer purchased shares of XYZ for $40 last year. Currently, with the stock trading for $65, your customer is concerned that the stock could drop sharply from its current price, although long-term, she wants to hold this investment if possible. You would recommend that she place
A. a market order to sell
B. a buy-stop order @66
C. a sell-stop order @67
D. a sell-stop order @64

EXPLANATION: the customer does not need to buy any more stock, so you can eliminate choice B. You can eliminate choice A since the customer thinks the stock may be worth holding long-term. A sell-stop order at $67 would be executed as soon as the stock traded at $67 or lower--since the stock is already there, the order would effectively be a market order to sell that might even cost the customer more $ to place than a market order to sell. Choice C, then, can be eliminated, leaving you with the right answer, D.

ANSWER: D

Buy Stops, Buy Limits

So, I guess I have to follow that last post with a discussion of buy-stop and buy-limit orders. Let's say you've been watching Starbucks lately. It last traded at $9.58 on Friday, so for whatever reason this price intrigues you. But, just like the older folks who attended my garage sale last autumn, you can't just buy something on the cheap. You insist on buying it even cheaper. No matter what price tag somebody sticks on a stock or a used waffle iron, frugal folks like you still insist on buying the thing a little cheaper. Fine. If you insist on buying Starbucks (SBUX) for $8 or lower, place a buy-limit order @8. Once you do that, you'll be in a position to buy SBUX as soon as the ask price drops to $8 or lower. What if the price drops to $8 or lower, filling your order, but then keeps dropping to, like $3, or, like, $1?
At that point you would be crying and wishing you had placed a buy-stop order instead. Why?
With SBUX trading at $9.58 a share, let's say you were intrigued but still nervous about the company's near-term prospects. There's a recession on, and it's not that hard for most people to cut back on their unnecessary spending. So, you're not ready to dive in, especially when you could see that stock dropping down to the low single digits. Then again, it's a great company, and as soon as the employment rate picks up again and wages start rising, people will probably go back to their old coffee and latte habits. So, you decide to play it both ways. You refuse to buy the stock if it's dropping from here. But, if it rises to a certain target point, you buy it automatically. The stock has to show you it has legs first, in other words, and only then will you buy it. Won't you end up paying more that way? Yes. If you enter a buy-stop @12 on SBUX, you will end up paying $12 if the stock rises to that point. On the other hand, if the stock drops quickly to $2 or $3 from here, you won't touch it.
This example isn't just academic for me. I help a good friend manage his IRA. He's normally very sensible, but when he saw SBUX trading in the high teens a few months ago he was convinced he needed to buy it. I was convinced that Starbucks was entering a period of scary pain that would last at least 3 - 5 years, possibly ending in bankruptcy. With the stock at $17, I didn't recommend buying it at all, but I could only get him to compromise on placing a buy-stop @20. If the stock had risen from there, he would have bought it. Of course, we just saw that the stock has dropped to the $9 range and may well drop further. The buy-stop @20 never executed and then dropped off after 6 months. Thank God for buy-stop orders. They put the investor in a position to buy stocks that are rising in value, avoiding stocks that are dropping in value. If, on the other hand, you place a buy-limit order, you will buy the stock only if and only as it is dropping. Kind of a dangerous game if you think about it, like trying to catch a falling knife.