First, remember that a stop-loss order is a limit order placed with a broker to sell a stock when it reaches a certain price. It is designed to limit an investor's loss on a stock position. Therefore, limit orders do not apply to the trading of mutual fund shares. (For related reading, see The Basics Of Order Entry.)
To better understand this circumstance, it's worthwhile to look at the structure of a mutual fund and how shares of a fund are bought and sold. Unlike stocks, which are traded on a stock exchange, mutual fund shares are issued (bought by investors from the fund) and redeemed (sold by investors to the fund) by the fund, which is why the formal designation of the most prevalent form of a mutual fund is open-end.
Fund companies issue and redeem shares of an open-end mutual fund according to the desires of the investing public. At what prices are these transactions executed? Here is where we see a fundamental difference between the trading of stock and mutual fund shares.
|Watch: Stop Loss Order|
In the case of stock, a company issues a finite number of shares and, after an initial public offering (IPO), these shares trade on the secondary market. A stock's share price is determined by the forces of supply and demand - in other words, the market sentiment among buyers and sellers.
Mutual fund shares are priced, for both purchase and sale, according to their net asset value (NAV). How is this value determined? In simple terms, a stock mutual fund has an underlying portfolio of stocks, and these stocks are "valued" according to their closing prices at the end of each day. A mutual fund's share price, therefore, is only determined once a day after trading is closed.
Obviously, stock prices march to a different drummer and constantly change throughout the trading day. When you buy or sell mutual fund shares on a Monday, you won't get a price fix until Tuesday.
Mutual funds can't be traded like stocks, which allow investors to use techniques such as limit orders, buying on margin, shorting, etc. Because of the trading limitations of mutual funds, professional investors pressured for a change, which resulted in the creation of the now very popular exchange-traded fund (ETF). An ETF is an index mutual fund that is listed on a stock exchange and can be traded with all the attributes of a stock.
To learn more about this investment vehicle, read Introduction To Exchange-Traded Funds.
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