Stop-loss? Limit? The orderly world of stock trades

Savvy investors keep it simple when buying stocks.

Market orders versus limit orders? Mostly, market orders rule. Stop-loss orders? Not worthwhile in most cases. Trailing stop orders? Mainly a way for brokers to make more in commissions.

These are the views of Patrick McKeough, one of the country's top experts on stock trading for mainstream investors, thanks to his background as publisher of The Successful Investor family of newsletters. If you're one of the many investors who have recently opened an online brokerage account, or if you want a second opinion on your own approach to buying and selling stocks, Mr. McKeough has some advice that can help get you trading more effectively.

To start with, stop worrying so much about whether the price you're going to pay or receive when you place your order is too high or low.

"People who are starting out obsess about this," Mr. McKeough said. "They have this feeling that you have to buy at the low and sell at the high to maximize their gain."

One of most effective ways to control the price paid or sought for a stock is to use a limit order, where you put a ceiling on what you'll pay and a floor on what you'll receive. The alternative is a market order, where you pay what sellers are asking when buying shares, and accept what sellers are offering when purchasing.

The advantage of a limit order is that you're protected if the price of a stock surges higher or plunges after you submit your buy or sell order. If the share price goes beyond your limit, no trade is made.

Back in the technology boom that began this decade, it wasn't uncommon for investors to get badly burned using market orders for a volatile tech stocks. They expected to pay something around the current market price at the time they submitted their order and ended up paying much more because the shares happened to surge higher at just the wrong time.

Mild versions of this outcome can happen any time you buy a stock with a market order. But where big, heavily traded stocks are concerned, Mr. McKeough thinks it's still better to use market orders. His argument is that limit orders too often represent a false economy. Let's say you want to buy a stock with a market price of $50 for $49 and not a penny more. But what if the stock then jumps to $55? You've missed out on a $5-a-share gain because you wanted to save $1.

"The more experience people have with investing, the less likely they are to go for the element of precision that calls for a limit order," Mr. McKeough said. "They realize that it isn't going to pay off."

Limit orders do make sense when you're buying a stock that trades only a few hundred or a few thousand shares on the average day. Take the case of Danier Leather. Its recent trading history shows totals of between 100 and 20,000 shares changing hands per day (aside from one day where 156,600 shares were traded).

On one particular day this week, a single trade had yet to be made by noon. At that point, the last trade for this stock was $5.30, buyers were bidding as much as $5.27 and sellers were asking $5.63. With a market order here, you could have ended up paying a per-share premium of 33 cents over the market price. With a limit order, you could have exerted some control over the price paid by specifying a ceiling of, say, $5.35. If that didn't work, you could try bumping up the price incrementally.

Mainstream investors trying to build a diversified portfolio probably shouldn't be buying a lot of stocks where limit orders are required, Mr. McKeough cautioned.

"If you're saying to yourself, 'what kind of a limit should I put on this stock so I don't get creamed,' then you're in something that should probably make up only a small part of your portfolio."

While he believes that limit orders have a place, Mr. McKeough is mostly dismissive of stop-loss orders. After the bear market plunges of last winter, the idea of a stop-loss order makes some sense because it allows you to instruct your broker to sell a stock if the market price falls below a preset price level. That's how you stop your losses.

The Investopedia website (investopedia.com) describes the stop-loss order as a free insurance policy that takes the emotion out of deciding when to sell. In a way, that's a good thing because investors tend to hang on to losing stocks too long. Stop-loss orders are also cheap enough that the cost of selling shouldn't be a consideration. Thanks to the decline in online stock trading commissions in recent years, you can pay as little as $10 to get out of a stock and no more than $20 to $29.

Still, Mr. McKeough argues that stop-loss orders are useful only when you have a speculative stock that has run up and you want to lock in a gain. With stocks that you're planning to buy and hold, stop-loss orders are unnecessary.

In fact, they can even be harmful. Mr. McKeough said it's not unusual for a stock to fall sharply at times on its way to longer-term gains. You could buy the stock back again after your stop-loss order kicks in, but you'll incur extra commission costs and probably have to pay more than you received when you sold.

"If you're buying good-quality stocks and you're sticking to the middle ones that don't look outrageously cheap and don't seem outrageously expensive, then I would absolutely eliminate stop-loss orders," he said.

A refinement of the stop-loss order is the trailing stop, which allows you to have a sale triggered if a stock falls by a set percentage as opposed to a particular dollar level. The appeal here is that you can let your stocks run higher while limiting the downside by an amount you control. If you have a $100 stock and have set your trailing stop for a loss of 20 per cent, you get sold out at $80. If the shares rise to $120, you'd be sold out after a decline to $96.

Mr. McKeough thinks trailing stops are another example of investors trying too hard to control the buy and sell prices of their stocks. Oh, and he also thinks they're a way for brokers to get clients to place more trades. "The more stops you put in, the more commission you're going to generate."

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