A bracket order is an order which a stock trader enters which allows them to place both a limit order and a stop loss order at the same time on a particular stock. Most brokers allow you to place only one order against a stock you own. This can be frustrating as you can either place a limit order to get out at a set profit or a stop loss order to protect against a falling stock price.
What if you could do both?
I asked one of my brokers this question and they told me this was impossible. Their system simply could not handle this. I questioned more and said how can a stock trade at say 11 and 10 within microseconds? They were not sure but knew their system did not do this.
Well, my other broker (Interactive Brokers) does. So when I am trading with them, I generally set up a bracket order as soon as I enter the trade. In fact, I place most of my trades after hours using buy stops or limit orders and attach a bracket order to the order. As soon as the order gets hit, I have a limit order and a stop loss order placed.
This has a large advantage for me as I know if I am in the stock I have both a stop loss protecting me against a major drop in the stock but I also have a profit target already working for me.
Now your trading plan needs to clearly define where to put both your limit and stop orders. Generally, I will place my limit orders to give me a 2 or 3:1 reward to risk ratio and my stop loss somewhere between 2 to 10% below my purchase price. It just depends on the trade.
As an example of how this might work let's look at the chart below. In this case I placed a buy on stop at around 4.06 just above the consolidation which occurred between October 12 and October 15, 2009. I bought into the stock when it made the break on October 16. As soon as the stock was purchased, a bracket order was entered with a profit target of 4.99 and a stop loss was entered with a price of 3.89.
Stock chart provided courtesy of StochCharts.com
With a risk of 0.17 (4.06 - 3.89) on the trade I decided to set my limit order at 4.99 which shows a reward to risk ratio of around 5:1. Three days later my limit order got hit and I was out of the stock. In this case, the bracket order worked extremely well. Not all trades work as well as this one.
When you predetermine your exit as I did in this case you can, at times, sell way before a run is completed. For instance, if this stock had run to say 7.43 I would be out at 4.99 leaving a lot of profit on the table. One needs to check in with their goals and trading plan to determine if they want to go for the occasional home run or consistent small gains.
As discussed earlier, bracket orders are not offered by every brokerage company. Interactive Brokers is one broker that I know which offers bracket orders. There are other brokerage houses which offer it but generally the ability to bracket an order is only offered in their advanced trading platforms which are quite expensive to use.
So how do bracket orders turn a losing trade into a winner? Well look at this situation. You buy a stock and it is going nowhere. Sometimes you are up a bit sometimes down. You want to keep your stop loss in to protect yourself but do not have access to the market during the day. You wait. If you added a bracket to the trade you could potentially get out at a small profit while maintaining your protective stop. This can turn a potential losing trade into a small win.
If you think this type of trading strategy could be useful to you and want to give it a try, you can pretend to set a bracket type order on your next couple of trades or look at your past trades and see if this type of order would help or hinder you.
I should mention that you can also place a stop limit order as your stop instead of just a stop loss. It really depends on how you trade.