Limit Order versus Stop Order

[notjusttp]

Hi David,

Can you pls clarify the difference in these 2 concepts ( Hull pg 35) To my understanding there seems no distinction as Limit order at $30 gets executed at that price as well as Stop order to sell at $ 30 also gets executed at that price.

Also to add to my confusion is the concept of stop-limit order ( Hull2.14) where you say in your solution manual that

"A stop limit order to sell at 20.30 with a limit of 20.10 means that as soon as there is a bid at 20.30 the contract should be sold provided this can be done at 20.10 or higher"

Once the bid is at 20.30 it would be sold that at that price only which necessarily would be above 20.10 then whats the logic of the words "provided this can be done at 20.10 or higher" and whats logic of stop + limit order ? :roll:


Thanks & Rgds
Amit

 

[notjusttp]

Hi David,

Any clue??

rgds
Amit

 

[David Harper CFA FRM]

Hi Amit,

The SEC has good help on this: http://www.sec.gov/answers/orderbd.htm

Say stock price is $30
A stop loss @ $25 is a "trigger" to sell if stock drops to 25 or lower;
e.g., stock goes to $25, stop loss is triggered and you have a "market order to sell" ... then stock ticks up to 26 before execution, you would sell @ $26 (b/c the stop loss is just a trigger to affect a market order)

instead say you enter a limit order to sell @ $25; stock briefly goes down to $25 but specialist cannot execute before stock goes up to $26. Unlike the stop-loss (which will be sold), you are not sold here because your limit is a price requirement.

so the stop is a trigger (do the order) and disregards to price change between order and execute; the limit puts a condition on the executed price and, therefore, it may not happen

David

 

[notjusttp]

Hi David,

That was a good explanation.,,Tks...Amit

 

[David Harper CFA FRM]

Amit,

I just noticed an example of where the difference matters:

http://blogs.reuters.com/columns/2009/10/12/the-victims-of-high-frequency-trading/
...this is a scary story, the guy took a bath b/c the stop loss triggered but a limit would have protected him

David

 

[hsuwang]

Hello David,

Can you help me with this following question:

An options trader sells a call with a strike price of $40. Which of the following describes a stop-loss trading strategy?
a. The trader holds the underlying stock.
b. The trader puts in a limit order for the stock if it rises above $40.
c. The trader puts in a buy order for the stock if it falls below $40.
d. The trader holds the underlying stock if the stock price rises above $40.

I'm guessing B would be correct, but I'm not sure about it.. If instead B says "stop order" instead of "limit order", would it still be correct? and also can D be correct as well since holding the underlying stock can in a way help prevent further loss.

Thanks.

 

[Liming]

Dear David,

I think the answer to Jack's question should be D, not be B. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. Firstly, the expression of B is ambiguous: I'm not sure if the question says "to buy the stock if it's 40 or lower or to sell the stock if it's 40 or higher"; Secondly, I think either case wouldn't make a good stop-loss tactic for shorting a call option that suffers only when the stock is rising: when stock is rising, the right thing to do to prevent losses should be to long the stock so as to benefit from the price rise, not to sell. This makes the first option seemingly okay but this gonna be generating some loss as well since this means that we are buying stock at higher price not lower price.

Thank you for your opinion!

Cheers
Liming
16/11/09

 

[David Harper CFA FRM]

Hi Liming,

Yes, exactly! I agree with everything you say, including choice (b) is ambiguous: the limit attaches to a price, so the meaniing of limit "if rises above" is unclear (?!).

This stop-loss refers to the following section in Hull, so choice (d) does appear to be correct:

Hull 17.3 (p 358, emphasis mine) "Stop Loss Strategy: One interesting hedging procedure that is sometimes proposed involves a stop-loss strategy. To illustrate the basic idea, consider an institution that has written a call option with strike price K to buy one unit of a stock. The hedging procedure involves buying one unit of the stock as soon as its price rises above K and selling it as soon as its price falls below K. The objective is to hold a naked position whenever the stock price is less than K and a covered position whenever the stock price is greater than K. The procedure is designed to ensure that at time T the institution owns the stock if the option closes in the money and does not own it if the option closes out of the money."