#Bracket orders

[updated the bracket order calculator on 6/25/2014.  Updated the text on 7/18/2014]

The bracket order is a trading order to buy a stock or other exchange-traded security while also placing an advanced order to sell the entire purchase at a future profit or loss.  The profit and loss exits are the brackets.  Some brokerage firms offer the bracket order to individual investors (1).  I use it to limit the loss that I might incur any time after buying the stock for a long position.  The bracket order has 4 elements: 1) Entry share price for buying the stock from the market. 2) Quantity of shares to buy. 3) Profit exit share price for selling the stock at a capital gain. 4) Stop loss exit share price for selling the stock at a limited capital loss.  Click on this link to the bracket order calculator worksheet to follow the discussion or plan your automated trade.

Taking the long position

Taking the ‘long position’ means to purchase a stock with the idea of selling it at a higher price.  But if the price falls, you suffer a loss in proportion to the size of the investment.   You can manage the risk of a loss by deciding how much money to sacrifice and using the bracket order to limit your loss.  Some investors typically plan to lose between 1% and 3% of their capital in a single trade.

Bracket order’s prices

LongPositions

The chart shows price movements for two imaginary stocks during a recent time period.  The wavy black lines are series of historical stock prices that end at the latest price on the right hand side.  Assuming that prices will continue to behave in the same way, the future prices will fluctuate between the levels of support (red dashed line) and resistance (green dashed line) until a substantial event dictates a change.  The support is the price ‘floor’ and the resistance is the price ‘ceiling’.   In between are the opportunities for profit and loss.  The ideal situation is to buy any stock near its support level and then sell near its resistance level, repeating the process over many trades to accumulate wealth.  The bracket order helps plan for these outcomes.

Suppose the latest price is suitable for investment.  Then plan to purchase the stock at approximately the latest price by placing either a market order to trade immediately at the current price or a limit order to trade at a specified or better price. Your desired purchase price is called the entry (yellow circle on the chart).   Your bail-out price is called the stop loss exit (red square), an automated order to sell the stock at a planned loss.  Your price for earning a profit is the profit exit (green square), an automated order to sell the stock for a capital gain.

Bracket order’s quantity

The final step is to calculate the quantity of shares to purchase.  The quantity is constrained to the planned loss on a per-share basis.

  • “Planned loss” is the amount of money you are willing to lose from a trade in the event of a market downturn
  • (loss/share) = entry – stop loss exit
  • quantity = planned loss / (loss/share)

The planned loss is typically less than the principal amount spent to purchase the shares (principal = entry x quantity).  You may choose to reduce the quantity in order to lower the principal.

Comments

CAUTION:  There’s no guarantee that the stop loss exit can prevent losing more than the planned loss when market prices are exceptionally volatile.  Prices typically move in small increments except in rare instances when they might plunge below the stop loss exit by several points to create a deep loss.  That’s why the SEC recently enacted “circuit breaker” rules to stop trading for any stock whose price changes sharply within a five-minute period (3).

RECOMMENDATION:  The future prices of any stock are uncertain.  Put more effort into determining the stop loss exit than in determining the profit exit by using historical prices to select a safe level of support (red square in the chart).  The profit exit reflects how quickly you want to sell for a gain; it’s better to think high and wait longer unless you’re a bonafide day trader.   Expect a longer holding period for the higher profit exit. If your brokerage firm’s trading platform allows changes, you can update the bracket order to protect gains and reduce losses as the prices rise with time.

Consider using the bracket order calculator to plan your automated trade.  If the program inspires your investing to support the betterment of society, consider making a tax-deductible contribution to your favorite charity or my favorite charity.

References

1.       Jean Folger. The pros and cons of automated trading systems.  Investopedia.com, August 24, 2011.  © 2014, Investopedia US, A Division of IAC.

2.       Investor Bulletin: New Measures to Address Market Volatility, SEC.gov, 4/9/2013.

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