Day Trading 101: The Stop Loss Order

One of the best ways to stick to a trading discipline is by using stop-loss orders to limit losses. A stop-loss order can be very effective in helping to maintain risk-reward ratios and in letting winners ride, while cutting losers quickly. Perhaps as important, these orders eliminate much of the personal angst involved when a stock goes against you, because the trade is automatically closed out, with no questions asked or emotions involved. Trading without emotions is key to long-term success.

Dynamics of the Stop-Loss

Stop-loss orders can be used for both longing, and shorting stock. They can limit losses while keeping risk-reward ratios unscathed. Sell-stops are used for protection of long positions and buy-stops are used for protection when shorting. For example, if you buy a stock at $50 per share, are looking to make four points, and have a goal to maintain a 3-1 risk/reward ratio, then you would set a stop loss order at 49, while looking to sell for profit if the stock reaches 54.

By setting a sell-stop order at 49, the stock will automatically be sold out of your account if the price hits 49. For the order to be “triggered”, the price must hit 49.00. Once this happens, the stock will be sold from your account at the next available market price, whether it is above or below 49.00 This is a key difference from limit orders, where not only does the price have to be triggered, but the order will only execute if it can fill you at a price “at or better” then your limit order price.

Avoiding Unnecessary Fills

Stop-losses are great for limiting losses, and are a benefit to the industry. However, one thing to keep in mind when utilizing the stop-loss is that market makers and specialists, who see all of the stop and limit orders in advance, will often artificially bring the stock price up or down to fill these orders before the stock can move in its natural direction. This is a way for specialists to make added commissions, and often occurs at levels where there are large amounts of stop orders. The closer the stock price is to your stop order, the more likely it will get filled.

Placement and Longevity of Stop Orders

Consequently, it is important to place stop orders below major support levels for longs and above resistance levels for shorts. This helps to avoid unnecessary fills at levels where most of these orders lie. Also, by setting them with the intention of possibly needing them a few days out rather then on the same day, it may be easier to find less conspicuous levels to place them. Stop-losses can be set to expire at the end of the trading day, or remain indefinitely, until the order is either filled or cancelled by the trader. Allowing the stock some breathing room, and placing orders below major support levels, may be easier to follow a risk/reward discipline and lead you to more winning stocks than losing stocks.

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