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From Wikipedia

A sell stop order is an instruction to sell at the best available price after the price goes below the stop price. A sell stop price is always below the current market price. For example, if an investor holds a stock currently valued at $50 and is worried that the value may drop, he/she can place a sell stop order at $40. If the share price drops to $40, the broker sells the stock at the next available price. This can limit the investor's losses (if the stop price is at or above the purchase price) or lock in some of the investor's profits.

I was wondering how to understand limit the investor's losses (if the stop price is at or above the purchase price)?

I think a sell stop order is for selling an asset that is already owned. So if the stop price is at or above the purchase price, then it is to lock in the profits. If the stop price is at or below the purchase price, then it is to limit the loss. This is contrary to the last sentence in the quote.

ThanksT

  • I think the text in brackets is positioned in the wrong place, it should be right at the end after 'lock in some of the investor's profits.' Looks like a typo in Wikipedia ! – Victor Jun 18 '12 at 11:57
  • @Victor - agreed, and if you click though, it's been 'fixed'. – JTP - Apologise to Monica Jun 18 '12 at 17:42
  • @JoeTaxpayer: That guy kept reversing your fixing. – Tim Jun 18 '12 at 19:38
  • @Tim - he wrote "No, you can only limit losses when you have losses - which means the sell price is above the original purchase price." English is my only language, but some days it fails me. I agree with you, but Wikipedia is not my cause. I think you caught an error that some wiki users wish to let stand. – JTP - Apologise to Monica Jun 18 '12 at 19:54
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It depends to some extent on how you interpret the situation, so I think this is the general idea. Say you purchase one share at $50, and soon after, the price moves up, say, to $55. You now have an unrealized profit of $5. Now, you can either sell and realize that profit, or hold on to the position, expecting a further price appreciation. In either case, you will consider the price change from this traded price, which is $55, and not the price you actually bought at. Hence, if the price fell to $52 in the next trade, you have a loss of $3 on your previous profit of $5.

This (even though your net P&L is calculated from the initial purchase price of $50), allows you to think in terms of your positions at the latest known prices. This is similar to a Markov process, in the sense that it doesn't matter which route the stock price (and your position's P&L) took to get to the current point; your decision should be based on the current/latest price level.

  • +1 for Markov process. Cool to learn something new like this. – JTP - Apologise to Monica Jun 18 '12 at 0:01
  • Tim may have caught a bit of a typo in that Wikipedia entry. I agree you limit a loss only when a loss exists. Your interpretation of limiting the downside from that last price is possible, but I think that's pushing it. Every position I have that's not at its all-time high would therefore have a "loss" from its peak, right? I might just edit that Wiki entry myself and call it a day. – JTP - Apologise to Monica Jun 18 '12 at 1:21
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    I suppose it's probably more a matter of semantics, but I do see your point. Agreed, perhaps it would be best to edit the Wikipedia entry and sound less ambiguous. – AK. Jun 18 '12 at 1:47
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    The entry now reads "This can limit the investor's losses (if the stop price is below the purchase price) or lock in some of the investor's profits." – JTP - Apologise to Monica Jun 18 '12 at 2:34
  • My edit has been reversed at Wikipedia. The author of the reversal seems to follow the loss from a given point, as compared to absolute loss. – JTP - Apologise to Monica Jun 18 '12 at 21:04

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