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Question

Difficulty: MediumTypes of Orders and Order Execution Strategies

An investor holding a long stock position currently valued at 45persharewantstomanagedownsiderisk.Theinvestordecidesthatifthestockpricedropsto45 per share wants to manage downside risk. The investor decides that if the stock price drops to 40 per share, an order should trigger to sell the position, but under no circumstances should the shares be sold for less than $38 per share. Which order type and price specification best fulfill the investor's execution requirements?

  1. A Sell Stop-Limit order with a stop price at 40.00andalimitpriceat40.00 and a limit price at 38.00Answer
  2. B
    A Sell Stop order with a stop price at $40.00
  3. C
    A Sell Limit order with a limit price at $40.00
  4. D
    A Buy Stop-Limit order with a stop price at 40.00andalimitpriceat40.00 and a limit price at 38.00

Answer

The correct order type is a Sell Stop-Limit order with a stop price of 40.00andalimitpriceof40.00 and a limit price of 38.00.
A Sell Stop-Limit order satisfies both requirements: it remains unactivated until the market drops to or through the 40.00stopprice,andonceactivated,itbecomesaselllimitorderthatcanonlyexecuteat40.00 stop price, and once activated, it becomes a sell limit order that can only execute at 38.00 or higher, preventing an execution below the investor's specified minimum threshold.

Step-by-Step Solution

1
Identify the position held and the market direction risk.
The investor owns a long position and is seeking protection against downside price declines below $45.00.
Orders to protect long positions against falling market prices must be placed below the current market price.
2
Determine the activation condition.
The activation price (stop price) must be set at $40.00.
The investor specifies that trading action should begin only when the price drops to $40.00.
3
Determine the execution constraint.
A limit price of 38.00mustbeattachedtopreventexecutionslowerthan38.00 must be attached to prevent executions lower than 38.00.
A market stop order does not guarantee execution price, whereas a limit price sets a strict minimum acceptable selling price.

Key Concept

Order Types and Execution Rules (Sell Stop-Limit Orders)
Estimated Time:1m 15s
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Topics

Types of Orders and Order Execution Strategies