Stop Orders Don’t Protect You From Gaps

This is really basic stuff that I hope won’t come as a surprise to most of my readers, but I figured I’d bang out a quick post because I saw some strange comments on the $VRNG stream.

A “stop” or “stop loss” order is an order that one enters in an effort to protect profits, or to limit losses.  If you are long a stock that is trading at $30, you might enter a sell stop order with a trigger price of $29:  this means that if the stock trades down to $29, your order is activated – it can become a market order or a limit order, depending on how you entered it.   This is very different from a $29 limit sell order – which would be immediately marketable with the stock trading at $30.

Anyway, it should be patently obvious that this stop order does NOT mean that you are guaranteed to sell your stock for no less than $29:  if your stock gaps down – maybe the CEO is arrested for looting the company’s coffers – and it opens at $12, that’s where your order will be triggered.

$VRNG is a particularly good stock to talk about the perils of stop loss orders because the company is involved in litigation that has a binary outcome.   The stock is likely to trade significantly higher or significantly lower depending on the outcome of their trial with Google ($GOOG: no positions).   So, if you have a sell stop @ $2.50 in VRNG, thinking that this means you can’t lose more than $1.30 per share (the difference between the current $3.80 price and your stop price), you are sorely mistaken.   If VRNG gets an unfavorable trial result, and the stock gaps down to $1.50, you will not be selling stock at $2.50.

Similarly, if you are short VRNG, and you think that you can limit your losses by placing a buy stop at $5.00, you will be in for a shock if VRNG gets a favorable result and the stock gaps up to $8.

Again, this is very basic stuff, which probably won’t be a shock to many readers.   I personally don’t ever use stop orders, although I may often have “stop” levels in my head where I will liquidate a position.

Note:  I am not saying that VRNG will trade to $1.50 on a negative verdict.  I am not saying that VRNG will get a negative verdict.   I am not saying that VRNG will gap to $8 on a positive verdict.  I am not saying that VRNG will get a positive verdict.  I am merely giving illustrative examples.    It should be clear to anyone who has read my previous posts on Vringo that I believe that there is a great deal of uncertainty in the outcome of the trial.

I hold bullish options positions in VRNG – November calls of various strikes.


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