Setting Limits

San Diego social worker Judith Wolfe and her aerospace executive husband, Emmet, would rather be sailing their 37-foot schooner than staying home and watching their stocks.

But the Wolfes, like many small investors, would like a little more peace of mind about their portfolio while they’re off doing something fun.

In particular, the Wolfes would like to be sure that if the stock market were to plunge suddenly, they would have a good shot at scooping up bargains while they last.

But how can you buy stocks if you’re out sailing?

By using “limit” orders. These are standing instructions to your broker to buy or sell a security at a particular price or within a certain price range.

All such orders, once entered, can be executed without your having to lift a finger again.

If, for instance, you are worried about a downturn in the market, you could ask your broker to place a limit order, known as a stop-loss order, to sell a particular stock if it falls to a certain price--in effect limiting your losses, or protecting any profits up to that point.

Limit orders work well with major stocks, but with less-liquid stocks, particularly those not traded on major exchanges, the orders may not be permitted, or aren’t practical--there may be only one trade a day in some stocks, for example, and their prices may move sharply up or down with each trade.

Don’t expect your broker to be enthusiastic about taking limit orders, since they can be a nuisance for small holdings and may never result in a transaction (which means the broker may never get a commission for the effort).

And in case you’re wondering, few professional investors use these types of limit orders. Instead, most pros protect their clients’ money in more sophisticated ways. Traditional down-market hedges, for example, involve buying “put” options on stocks, or “shorting” stocks or stock options or futures.

Professionals also can use indirect means such as program trading--computerized programs that issue buy and sell orders automatically when certain market conditions are met.

Neither program trading nor hedging via short-selling is practical for a small investor, however, because they may involve great expense and can be risky in their own right.

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A limit order, on the other hand, is free to put in place. The instructions either are forwarded to the exchange on which the stock trades, or stay on your broker’s books. If the stock does not move to the indicated price, nothing happens. Such an order will remain in place until executed or canceled.

(Longer-term, recent changes in stock trading rules may result in charges for investors who want to use limit orders. That’s because the trading-rule changes are narrowing stock bid and asked spreads for Wall Street dealers, resulting in better prices for investors but reducing dealers’ profits.)

Robert Walsh, an investment manager with Jenswold King & Associates in Houston, says his company doesn’t use limit orders for its clients, “but for the individual, it might not be a bad endeavor.”

Walsh cautions, however, that there are right and wrong ways to use limit orders, particularly stop-loss orders.

“The average investor should stand back and say, ‘Why did I buy this stock in the first place?’ And if that reason is still there, stay with it,” Walsh says, even if the stock’s price falls.

A stop-loss order makes the most sense, he says, “when you anticipate needing cash in the near future,” perhaps for a child’s school tuition or if you are about to retire.

Walsh says a stop-loss order can also be appropriate when an investor is already considering selling a stock for some fundamental reason: For example, perhaps a company’s securities were recently downgraded by analysts or by a stock or credit-rating agency because of doubts about earnings growth or expansion plans.

Carolyn Person Taylor, investment manager and president of Weatherly Asset Management in Del Mar, says she has recommended stop-loss orders for clients who are holding a stock that may be attractive for the short term but does not fit with their long-term plans.

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Say, for example, that a client has exercised employee stock options and thus has a lot of shares in a stock that still seems to be on the way up. In time, the client will want to own less of the stock, but for now he or she wants to ride its bull market phase.

Or perhaps a client has inherited a security that is performing nicely at the moment but that isn’t something the owner would have chosen for himself or herself.

John Lawrence Allen, a Carlsbad, Calif., lawyer and a former investment manager, takes an unusual approach. He suggests placing a stop-loss order with every new stock purchased.

Allen, who recently wrote a book, “Investor Beware!” (John Wiley & Sons), on how individuals can protect themselves from unscrupulous brokers, says investors should consider the worst-case scenario and ask themselves: “Can I afford to lose any of my money? And if so, how much can I afford to lose?”

“If you buy 1,000 shares of a stock at $10 a share and you have decided that the most you can lose on this transaction is $2,000, you have thus determined that the stock cannot go below $8 a share,” Allen says.

Once you have established that limit, Allen’s advice is to “enter a stop-loss order at that price. So if your stock were to trade at $8, your stop-loss order would be executed and, depending on the size and liquidity of the market, you would generally sell your stock at or around the stop-loss price.”

Note, however, that because limit orders are generally activated with the next trade after the designated price is reached, the stock may not be traded at the exact price you request. In a volatile market, or with thinly traded issues, prices can move very quickly--and the next trade could be well above or below your limit price.

Taylor takes a more traditional approach toward limit orders. She advises looking at several factors, including company growth, share price volatility and tax implications, before entering a stop-loss order. She suggests using these primarily to preserve gains on stocks you already own.

How do you determine the price at which a stop-loss or other limit order should be set?

Experienced traders usually set a stop-loss at least 20% below the current market price. Taylor advises that you first study a chart of the trading price of the security over a period of three to five years.

“Set the price at just below the normal fluctuation range so that you don’t sell off a normal bounce,” she says. In other words, you may want to exit a stock via a stop-loss order at the point where the stock would appear to be heading into a true bear-market decline, not when it is simply jumping around within its usual price range.

In the case of stocks on which you already have a paper profit, and want to protect some or all of it, note that if you set a limit order sale price too close to your purchase price, the tax liability and brokerage fee incurred may wipe out any gains you would have realized from the share price appreciation.

Allen adds another warning, based on his observation of investors’ bad habits: Once you put a stop-loss order in place, stick with it.

“All too often I’ve watched investors consistently remove stop- loss orders only to replace them at lower prices. Once I watched an investor initially place a stop-loss order on a stock at $40 per share. By the time the investor was finally stopped out of his position at $12 per share, he had replaced the stop-loss order no fewer than 10 times.”

But other experts note that stop-loss orders, and other limit orders, may, in fact, need to be adjusted upward periodically, in a rising market.

If you buy a stock at $30, for example, and you set a stop-loss order at $25, you may want to raise the stop-loss price if the stock surges, assuming that you want to protect some of your paper gains.

Charles Crane, chief market strategist for Key Asset Management in New York, says he is concerned that clients may place ill-considered stop-loss orders during a market downdraft and thus be out of a stock for the next big updraft.

Although he stresses the importance of understanding the fundamentals of a stock rather than trading against the market, Crane says he does understand the nervousness of small investors with unprotected profits.

His solution? “My preferred strategy for investors who wish to protect gains over the course of time is to do, in reverse, a little bit of dollar-cost averaging,” he said.

“Establish in one’s mind a price objective for the stock,” Crane said. When the stock reaches the target price but continues to show upward momentum, he says, “scale out of it in increments,” which can be done with formal limit orders to sell at various prices.

“For example, if you own 500 shares of a stock and your target price is $20, sell 100 shares at $24, another 100 at $26, $28 and so on. In that way, indeed if the market advances strongly, you will participate,” Crane said.

At the same time, you could still keep a $20 stop-loss order for the entire batch of shares, Crane said.

Taylor points out that investors can use the same gradual-exit strategy in connection with limit orders as a stock falls. If an investor bought shares at $50 and the stock is trading now at $100, for example, the investor may put a stop-loss order on one-third of the shares at $90, another one-third $80 and the last third at $70.

But Steven Vanelli, a portfolio manager at KJMM Investment Management in San Francisco, wouldn’t use any of these methods to protect profits. He prefers the approach of the strict value investor.

“When you feel the security is adequately priced, sell the blessed thing. Don’t go for the last nickel.”

Vanelli sticks by a simple rule: “Nobody ever went broke taking a profit.”

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Limit Orders: A Glossary

Limit orders placed with your broker can be used to protect profits or limit losses on individual stocks you own, or get you into a stock once a predetermined market price is reached. Such orders, when designated as “good-till-canceled,” remain in place and are triggered automatically if your conditions are met. An order would generally be activated with the next trade after the designated price is reached, and thus may not be at the exact price you requested--in fact, in a rapidly moving market, the price you get could differ sharply from the price you set. You can designate a time or price range for limit orders as well. Here are a few basic types of limit orders:

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Buy stop order: A limit order to buy when a stock rises to a particular price in the market. Also called a “suspended market order.” Although it may seem odd to choose to wait until a stock rises to buy it, this specialized order could be used to protect the investor, such as to limit the potential loss on a stock that has been sold short.

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Limit order to sell: An order to sell when a stock reaches or trades above a particular price in the market. Can be used to automatically take a profit once a rising stock reaches an investor’s target.

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Limit order to buy: An order to buy when a stock falls to or below a particular price in the market. Can be used to ensure that an investor gets into a stock on significant downdrafts that might only be temporary.

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Stop loss order: A limit order to sell when a stock declines to a particular price in the market. Can be used to minimize losses in a stock that drops after you buy it, or to protect a certain amount of profit already made on paper. Also known as a “sell stop order.”

Researched by JANET LOWE / For The Times