If you've followed stocks for a while, you've inevitably seen it happen more than once. A stock that you've had on your watch list for a long time drops to a ridiculously low price at some point during a particular volatile day -- but by the time you find out about it, the stock has already rebounded substantially, and you've missed the perfect opportunity to buy at a low.
Seeking smart value
In general, of course, paying an extra point or two for a stock won't make or break you if you're investing for the long term. Sure, you want to pay as little as you can, but as Warren Buffett found out in missing out on Wal-Mart early in its growth phase, sometimes it's an even bigger mistake not to pay the extra money to get into a quality stock.
But especially with so many great values around right now, value investors can afford to be choosy. Assessing a stock's intrinsic value and then building in a reasonable margin of safety can mean the difference between a good investment and a great one -- and in today's market, you need as much safety as you can get.
How can you cash in on a temporary stock drop without sitting in front of your computer all day? It's simple -- by using limit orders.
How your broker can help you
Many people use limit orders every time they buy a stock. That way, they guarantee they won't pay more than they expect for a stock. In contrast, market orders, where you agree to pay whatever it takes to buy a stock, can end up costing you -- especially with illiquid stocks.
But limit orders aren't just for immediate trades. Most brokers will let you set limit orders that will stay effective beyond the trading day. If you do, you don't have to worry where you'll be when a stock drops far enough to meet your price target -- your order will execute automatically.
That can create some really attractive opportunities. For instance, last November, the markets were particularly volatile, and many stocks saw their prices drop temporarily on Nov. 20 and 21. But later -- sometimes the same day -- shares had jumped by a huge amount. Below are a few well-known stocks that are good examples of this phenomenon:
|
Stock |
Low Limit Price |
Price on Nov. 24 |
Change From Low Price |
Change From Nov. 24 Price |
|---|---|---|---|---|
|
BHP Billiton (NYSE:BHP) |
24.53 |
33.42 |
59.9% |
17.4% |
|
Best Buy (NYSE:BBY) |
16.42 |
19.89 |
69.9% |
40.3% |
|
Chipotle Mexican Grill (NYSE:CMG) |
36.86 |
42.61 |
50.6% |
30.3% |
|
Freeport-McMoRan (NYSE:FCX) |
17.27 |
21.92 |
66.6% |
31.3% |
|
Lockheed Martin (NYSE:LMT) |
67.38 |
72.74 |
15.4% |
6.9% |
|
Mosaic (NYSE:MOS) |
21.94 |
27.16 |
93.8% |
56.6% |
|
Petroleo Brasileiro (NYSE:PBR) |
14.73 |
19.31 |
80.3% |
37.5% |
Source: Yahoo! Finance. Low limit price is low for Nov. 20 and 21. Price changes exclude income from dividends.
Sure, you would've made good profits from buying even a day or two after stocks hit bottom. But the returns if you happen to catch those short-term lows are spectacular.
Two risks
With long-term limit orders, you run two different risks. The first is that if you pick too low a price, your order may never execute, meaning that you'll miss out on shares. If you're 100% certain how much you want to pay, that's not a problem -- but more often, you simply pick a limit price arbitrarily based on an acceptable range of prices you'd be willing to pay.
The other risk you run is that if the company comes out with bad news, then the stock may fall far enough to trigger your limit order -- yet the same bad news might change your opinion of what price you'd like to pay. If you catch it in time, such as while the market is closed, then you may be able to cancel your order -- but that can be a dicey proposition. Often, you'll end up stuck with shares you no longer want.
Balancing those risks and weighing them against the potential rewards, however, you may find that limit orders can save you the hassle of following the market constantly. If so, check with your broker to make sure you set your order correctly -- or if your broker doesn't offer them, find one that does.
For more on broker-related issues, check out:
- Why you need a broker.
- Ten ways you can size up your broker.
- How to invest any amount of money.
