"BUY ON STOP WITH A LIMIT" ORDERS

Initially, my plan for this week was to continue our discussion of the principles of volume analysis (this has been the topic of our last several "Inside The Black Box" articles). However, over the past few days we've received a large number of email inquiries from subscribers wanting clarification regarding what a "buy on stop order with a limit" is, why I use them, and how they can implement this type of order in their online brokerage account. As such, I am going to cover this concept in today's issue and will return to my series on volume analysis next week.

For starters, let's take the case of a trading idea I presented you with on Tuesday, September 16th -- Earthlink (ELNK). When I first introduced you to the stock, ELNK had closed at $8.99. As a trading strategy, I set a "buy on stop limit order" just a touch above the stock's closing price. I set the buy on stop order at $9.05 and the limit at $9.25. In summary, what this meant was that we would only purchase the shares if they continued higher, trading to $9.05 or above (the "buy on stop" portion of the trade), but if the stock gapped open higher than $9.25, then we would not purchase the shares (the "limit" portion of the trade).

In this case, I used a buy on stop order to ensure that we only entered the trade if ELNK continued its uptrend the following day. The stock had just broken out of a multi-month ascending triangle pattern on 2X its normal daily volume; it was not over-extended from this base. Given this technical configuration, ELNK was unlikely to immediately reverse course and decline on its own merits. However, if an unexpected event had hit the market overnight -- such as a poor economic report or a negative geopolitical event -- then the entire market could have sold off and taken ELNK with it. In this case, the shares would have probably traded lower the following day, so our buy on stop order would most likely not have been triggered. By using this type of order, we were able to ensure that we would only purchase ELNK if its previous uptrend continued.

If you don't want to watch the stock in intraday trading, then you can always enter this type of trade with your broker ahead of time. In contrast to a market order, which is executed at the prevailing market price when it hits the trading floor, a buy on stop order is executed only when a stock hits a specific price. In order words, if the stock does not reach that level, then the trade is never entered. (More on how to implement this type of trade below.)

A limit order sets the highest price at which I am willing to enter the trade. I typically use this type of order to make sure that I do not enter into a long position at an overly high price. If ELNK had rallied strongly in pre-market trading on Wednesday morning, for example, and opened at $9.75, then a large gap would have been created between Tuesday's close and Wednesday's opening. In that case, a large portion of the trade's profit potential would have been eroded and the risk of a losing trade increased. Since the breakout pattern on ELNK looked promising, I set a pretty "wide" limit to buy the stock up to $9.25. In this case, the limit was unnecessary and we entered the trade at $9.05.

The online discount broker I trade with is called Interactive Brokers. It is impossible for me to be familiar with the trading platform for every reader, but I'll explain to you how I place a buy on stop order with Interactive. My suspicion is most trading platforms will be similar and the process close to the same. I would be extremely surprised if your broker did not allow you to place a stop order, so the real question is whether you can attach a limit price to this stop.

For starters, Interactive Brokers has a simple order entry line. In that line, I first enter the symbol and the number of shares I wish to buy. The next column over allows me to choose the order type. Here the pull down menu allows me to create a "STP LMT" order, which stands for Stop Limit.

At this point I'm taken to two price screens. One is called the "Aux Price," which stands for Auxiliary Price. This is the price at which I want to set my stop order. In the case of ELNK, the price I would enter here is $9.05. The other column is the "Lmt Price," or Limit Price. Since I wish to pay no more than $9.25, I would enter that price in this column.

The final step is to specify that this order is meant to initiate a transaction from the long side. To achieve that, I then hit the "Buy" button. On Interactive Brokers, a separate line appears below the line on which the stock streams. It specifies that I have placed an order to buy ELNK as soon as the stock trades at $9.05. I will, however, pay no more than $9.25.

A buy on stop order with a limit has now been placed.

If for some reason you wish to short ELNK, then you would follow the same procedure above, except you would hit the "Sell" button. Let's say you wanted to short ELNK if it broke support at $8.40, but did not want to enter the trade at a price lower than $8.25. You would then go through the same procedure as noted above, but in reverse. In the auxiliary price field you would enter $8.40 and in the limit field $8.25. You would then hit the "Sell" button to place a sell on stop with a limit order.

If your broker does not allow you to place this kind of order, then you can still execute this type of trade as long as you are at the trading screen and actively following the stock. However, before you assume you can't set a buy or sell on stop with a limit order, it's probably worth emailing your broker to verify that fact. In addition, most online brokers offer help desks and convenient 1-800 numbers to field common questions such as these.

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