A:

Many individuals are hesitant to invest in the stock market because of the large gaps in prices talked about in the news. It is not totally uncommon to see a stock that closed the previous session at $55 open the next trading day at $40. This kind of volatility can result in massive losses, but this is the risk that all investors take when trying to make money in the stock market.

Regardless of the type of order placed, gaps are events that cannot be avoided. For example, assume you hold a long position in XYZ Co. It is trading at $55, and you place a stop-loss order at $50. Your order will be entered once the price moves below $50, but this does not guarantee that you will be taken out at a price near $50. If XYZ's stock price gaps lower and opens at $40, your stop-loss order will turn into a market order and your position will be closed out near $40 - rather than $50, like you had hoped. On the other hand, if you decided to enter a limit order to sell at $50 (instead of the stop-loss discussed above) and the stock opened the next day at $40, your limit order would not be filled and you would still hold the shares.

As you can see, if you are worried about a gap down in price, you may not want to rely on the standard stop-loss or limit order as protection. As an alternative, you can purchase a put option, which gives the purchaser the right but not the obligation to sell a specific number of shares at a predetermined strike price. Holding a put option is a good strategy for traders who are worried about losses from large gaps because a put option guarantees that you will be able to close the position at a certain price.

To learn more, see The Basics Of Order Entry, Understanding Order Execution and our Options Basics tutorial.

RELATED FAQS
  1. How does a stop-loss order work, and what price is used to trigger the order?

    A stop-loss order, or stop order, is a type of advanced trade order that can be placed with most brokerage houses. The order ... Read Answer >>
  2. What is the difference between a stop loss order and a limit order?

    Learn how to manage losses and reduce risk in volatile markets while reviewing the differences between stop-loss orders and ... Read Answer >>
  3. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Answer >>
  4. How can I use a stop order to limit my losses on a long stock position?

    Learn about stop orders, different stop order types, and how to use stop-loss orders and stop-limit orders to limit losses ... Read Answer >>
  5. How do I place an order to buy or sell shares?

    Read a brief overview of how to open a brokerage account, how to buy and sell stock, and the different kinds of trade orders ... Read Answer >>
  6. I want to buy a stock at $30, sell when it reaches $35, don't want to hang on to ...

    Once you've identified a security that you want to purchase, you need to determine a price at which you want to sell if the ... Read Answer >>
Related Articles
  1. Trading

    The Stop-Loss Order - Make Sure You Use It

    It's a simple but powerful tool to help you implement your stock-investment strategy. Find out how.
  2. Trading

    The Basics Of Trading A Stock

    Taking control of your portfolio means knowing what orders to use when buying or selling stocks.
  3. Trading

    Playing The Gap

    Learn how you can earn money by analyzing the disruptions in normal price patterns.
  4. Investing

    Making The Trade: Understand Order Types

    Buying and selling stock can be a lot like buying or selling a car. Traders should use and understand tools such as market orders, limit orders, day orders, and good-'til-canceled orders to ensure ...
  5. Small Business

    A Look At Exit Strategies

    Setting appropriate exit points should help you avoid taking premature profits or running losses.
  6. Investing

    Gap Strategies To Try For Intraday Trades

    Many traders lack effective strategies to manage gaps, whether they pop up on open positions or mark the first play of the day. These strategies may help.
RELATED TERMS
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches ...
  2. Bracketed Buy Order

    A buy order that is accompanied by a sell limit order above the ...
  3. Gapping

    In general, a trading strategy in which the participant borrows ...
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number ...
  5. Exhaustion Gap

    A gap that occurs after the rapid rise in a stock's price begins ...
  6. Buy Limit Order

    An order to purchase a security at or below a specified price. ...
Hot Definitions
  1. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that decreased and eventually eliminated tariffs to encourage economic activity ...
  2. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  3. Derivative

    A security with a price that is dependent upon or derived from one or more underlying assets.
  4. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  5. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  6. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
Trading Center