In an effort to answer the many questions we've had over the last several months concerning trading techniques, I have decided to write some articles covering the topic over several installments. Since risk management is the most important aspect of trading, we'll start with an installment covering some basic risk control using Stop Orders. In the next installment I'll use an example of a real trade to demonstrate the techniques discussed in this article. Here we go!

Many trading techniques can be used to control risk. The most common technique is Stop Orders. Being familiar with effective types of Stop Orders and their placement is crucial. (They can also provide well-needed discipline for traders.) Although Stop Orders can be used in ways other than controlling risk, (i.e. a Buy-Stop) simplicity dictates that we discuss Stop Orders from a risk management standpoint only We will focus on types of Stop Orders, choosing Stop Order placement, and circumstances that may necessitate changing order types during the life of the trade.

Stop Order Basics

The most commonly used Stop Order is a Sell-Stop Order (commonly referred to as a "Hard-Stop") that states, "Sell when a set price or lower is reached." If you purchase XYZ for $20.00/share and place a Sell Stop Order at $19.00/share, your position will be closed at or around $19.00/share. This basic Stop Order becomes a live Market Order as soon as the order is triggered. If there are no more bids (buyers) at $19.00 when the order triggers, your order could be executed at the next available price. This could be above or below $19.00, depending on volatility. This is one of the caveats of the basic Stop Order. However, it is simple and effective.

Stop/Limit Orders

Stop/Limit Orders are more specific regarding the instructions by which an Order will be executed. Again using 100 Shares of XYZ purchased at $20.00 a Stop/Limit Order would be placed using two prices: the Stop Order price itself ($19.00), and the Limit Order price. The Limit Order price is the least possible price you are willing to accept. If $18.50 is used as the Limit portion of the Stop/Limit Order, then execution of the order will trigger at or between $ 18.50 and $19.00. This seems wonderful but beware: if XYZ does not trade within the price ranges you have specified in your Order, the Order will not get executed at all. For example, if the stock gaps down under $18.50 at the open of trading and never goes back up to 18.50, you will still own XYZ. This is because the equity never traded within your specified parameters. Your Order stands in wait of an execution that may never come.

Trailing Stop Orders

Trailing Stop Orders are unique in that that they move parallel to the trade. Similar to the Stop/Limit Order, two input values are required. We will use 100 shares of XYZ stock purchased at $20.00/share with a Trailing Stop at $19.50. If the equity price moves down, the Stop will stay firmly in place at $19.50 and will trigger only when 19.50 is reached. It then becomes a live Market Order. If the stock begins to move above your purchase price, the second input value - the Trailing portion of the order - will activate. Most brokers will allow you to determine whether you want to trail the Stop Order by a specified percentage value or a specific dollar amount. Let us place a Trailing value of 20 cents. For each 20 cent increment that XYZ moves upward, the Stop Order will move upward by 20 cents as well. The seemingly obvious benefit of this type of Stop Order is that it lessens the risk of the trade as the price moves in your favor, but with all Resting Order types, there are caveats. This type of Stop does not move back down as the price declines. The Trailing Stop only follows the price as it increases. If the price declines, the Stop has now become tighter - possibly too early in the trade - leaving less opportunity for the trade to fluctuate this may lead to being Stopped-Out early. The amount you lose may be smaller than your initial anticipated risk, but you may be out of a viable trade that was violated simply by trailing the Stop too closely.

Conclusion

All Stop Order types have their own inherit caveats. The use of Stop Orders is an indispensable tool to the Day Trader, Swing Trader, and Long-Term investor alike. Risk should always be assessed carefully. Once that risk amount has been determined Immediately place Stop Orders once the trade has been filled. Do not remove the Stop until the trade has been closed.

The use of Stop Orders will provide the discipline needed to be involved in the markets for a long time to come.

Please feel free to contact me with any questions or comments you may have.

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