"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.

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