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. 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 >>
  2. How does a stop-loss order work, and what price is used to trigger the order?

    A stop-loss order specifies that an investor wants to execute a trade for a given stock, but only if a specified price level ... Read Answer >>
  3. What types of investors are best-suited for stop loss orders?

    Use a stop-loss order to mitigate downside risk. Whether you are a conservative beginner or a seasoned day trader, a stop ... Read Answer >>
  4. How do I place a limit order online?

    Learn how a limit order is placed, the types of stocks it is most useful for and the specifications placed with it to suit ... 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

    Which Order to Use? Stop-Loss or Stop-Limit Orders

    Stop-loss and stop-limit orders can provide different types of protection for investors seeking to lock in profits or limit losses. Investors need to know how each type of order works to know ...
  3. Trading

    Playing The Gap

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

    A Look At Exit Strategies

    Setting appropriate exit points should help you avoid taking premature profits or running losses.
  5. Trading

    Know How To Manage Gaps On Your Trading Strategy

    Gaps generate profitable strategies right after they print, as well as during retracements that test those levels, often months or years later.
  6. Investing

    3 Cases When Not to Place Tight Stop-Loss Orders (IBB, XBI)

    Learn about using stop-loss orders for exchange-traded funds. Discover the circumstances when using a tight stop-loss order may not be appropriate.
  7. Trading

    The 4 Advantages of Options

    Flexible and cost efficient, options are more popular than ever. Find out why.
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. Stopped Out

    The execution of a stop-loss order. Stopped out refers to when ...
  4. Gapping

    In general, a trading strategy in which the participant borrows ...
  5. Immediate Or Cancel Order - IOC

    An order to buy or sell a security that if not immediately filled, ...
  6. Exhaustion Gap

    A gap that occurs after the rapid rise in a stock's price begins ...
Hot Definitions
  1. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  2. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  3. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
  4. Pari-passu

    A Latin phrase meaning "equal footing" that describes situations where two or more assets, securities, creditors or obligations ...
  5. Interest Rate Swap

    An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for ...
  6. Custodian

    A financial institution that holds customers' securities for safekeeping so as to minimize the risk of their theft or loss. ...
Trading Center