Chapter 3 Flashcards
Describe how, if at all, a conservative and an agressive investor might use each of the follow types of orders.
a. market.
b. limit.
c. stop loss
a. Market orders are used when investors want to buy or sell a security quickly and are willing to
trade at the current market price. Aggressive investors who buy and sell frequently to capture
short-term price movements might use market orders to get in and out of positions quickly.
b. Limit orders are used when investors want to buy or sell a security and want to trade at a
specified price. Cautious investors will use limit orders to protect themselves from large and
rapid price fluctuations. Aggressive investors may use limit orders to automate trades once
certain profit goals have met.
c. Stop-loss orders are used when investors want to protect themselves from significant losses. After
buying a security, they enter these orders at a price below their purchase price to limit the amount
of their potential loss. Stop loss orders are mostly used by cautious investors to protect
themselves against large downward price fluctuations and to protect profits.
3.5 Al Cromwell places a market order to buy a round lot of Thomas, Inc., common stock which is traded on the NYSE and is currently quoted at 50 dollars per share. Ignoring brokerage commissions, determine how much money Cromwell probably have to pay, if he had placed a market order to sell, how much money will he probably receive?
- Mr. Cromwell’s market order to buy would have been filled at the lowest price available at the time,
while a sell order would have been filled at the highest price available at that time. However, since
market orders are executed quickly, it is reasonable to expect that Mr. Cromwell would have paid
$5,000 for his market order to buy a round lot (100 shares at $50 a share).
He would also have realized $5,000 for his market order to sell common stock. Of course, we have
ignored brokerage commissions and other incidental costs. On the NYSE, only one price is quoted,
and both buy and sell orders could be executed at that price.
- 6 Imagine that you have placed a limit order to buy 100 shares of Sallisaw Tool at a price of 38 dollars, although the stock is currently selling for 41 dollars. Discuss the consequences, if any, of each of the following situations.
a. The stock drops to 39 dollars per share 2 months before cancellation of the limit order.
b. the stock price drops to 38 dollars per share.
c. The minimum amount stock price achieved before cancellation was 38.50 and jumped to 47.50 per share.
a. The order will not be executed. The limit order will be executed only if the stock price falls to
$38 or below. However, since there are two more months before the limit order expires, it is still
conceivable that the stock price might fall to $38.
b. At a price of $38 per share, your broker will buy 100 shares of Sallisaw Tool stock at a total cost
of $3,800.
c. This example illustrates that a limit order, while effective, can also prevent an investor from
engaging in a transaction. Since the stock price did not go below $38.50, the limit order expired
without being executed. Consider what would have happened if you had bought the stock at $41
instead of placing a limit order. You could have sold the stock for $47.50 per share, realizing a
profit of $650 over the same time period (i.e., 100 shares at $6.50 profit per share).
3.7 If you place a stop-loss order to sell at 23 dollars on a stock currently selling for 26.50 per share, what is likely to be the minimum loss you will experience on 50 shares if the stock price rapidly declines to 20.50 per share.
The minimum loss that you would experience in this case is $3.50 per share, or $175, on the total
investment (50 shares at $3.50 per share). It is important to realize that this is a minimum loss. This is
because when the stock price falls to $23, the stop-loss order is converted to a market order to sell at
the best price available at that time. However, it is possible that the actual stock price might plunge
down further, in which case the stock would be sold below $23 per share (possibly at $20.50 in this
example). In this case, the loss would be $6/share, or $300 total.
3.8 You sell 100 shares of a stock short for 60 dollars per share. You want to limit your loss on this transaction to no more than 1,000. What order should you place?
You should place a stop-loss order to buy 100 shares at $45.
3.9 You have been researching a stock that you like, which is currently trading at 50 dollars per share. You would like to buy the stock at 47 per share. You believe that the stock will go to 70 by the years end. You decide to place a limit order to buy 100 shares at 47 dollars and a limit order to sell at 70 dollars. The stock goes to 75 dollars. What is your position?
Since the stock never fell to the limit order buy price, you never purchased it. However, you sold it at
$70 per share, so you are now short 100 shares. Because the stock is currently selling for $75, your
current position is a loss of $500.
3.10 You own 500 shares of Ups and Downs Inc stock. it is currently priced at 50 per share. You are going on vacation and you realize that the company will be reporting earnings while you are away. To protect yourself against a rapid drop in the price, you place a stop limit order to sell 500 shares at 40 dollars.
A stop limit order to sell 500 shares at $40 initiates the sale of the stock once the price hits $40.
However, the sale will occur only if the stock price is $40 or better. If the price dips below $40, no
shares will be sold until the price returns to $40 or higher. In light of the fact that the stock price
returned to $42 by the end of the day, it is likely that you sold 500 shares at a price between $40 and
$42.
You have 5,000 dollars in a 50 percent margin account. You have been following a stock that you think you want to buy. The stock is priced at 52 dollars. you decide that if the stock falls to 50 dollars, you would like to buy it. It falls to 50 dollars. What will likely happen?
Probably nothing will happen. Although you placed a stop-limit order to buy the stock, and the limit
price was hit, you did not have enough equity in your account to make this transaction. Three
hundred shares at $50 per share would cost $15,000. You could make this purchase with $7,500 in
your 50% margin account but not with $5,000.
