Financial Reality Revisited Headline Animator

Monday

Limit losses with Stop limit orders

The best way to protect against a major loss is by using trailing stops or stop limit orders. The theory is that you are better off to take several small losses while you search for the big winner. If you place a stock order and you are wrong about its direction you will lower your risk of loss by having a stop limit order in place. The Stop Limit order allows you to place an order based on the price you are willing to accept if the stock goes below a certain point.


For example: if you buy a stock that is $100 per share, and you think it is going to go to 110 you might want to put in a stop limit order at 98. If the stock moves down your order will be activated at 98. If the stock is not heavily traded you may be able to have it sell off right away but it is a good idea to put your activation price higher than your bottom line sales price. You could use 98.50 as your activation price and 98 as your sale price. If the stock is moving down quickly and you do not activate at a higher price, you might not get your order filled. The stock might go from 99 to 97 without anyone buying your 98. Basically you will get “jumped” over and your limit order will still be in at 98 when the stock is down to 95 a share. One your price is missed, which it often will be the case if your activation and sale price are the same, you will have to sell at a lower price, cancel the sell completely or wait until the stock bounces back up and triggers your stop order that sells. This is sometimes what you don’t want though because if it makes it back up to your stop price it might be moving higher. If your order gets missed on the way down you should either manually enter at a lower price to prevent further losses unless you believe the stocks will be back up again. It may or may not so that will be the question you have to ask yourself if those circumstances show up during your trading day.
You will have to learn to take several small losses in order to capture more gains. However, when you are using a trailing stop or stop limit you might get "stopped" out right before the stock makes a big run upward. It is more art than science when it comes to deciding what price to use or how much loss you are willing to accept. You will also have to watch the particular stock you are trading in order to get an idea of its volatility. The stop order will be much different for Apple then it will be for Microsoft. I am still somewhat surprised that stop loss or stop limits orders are rarely mentioned on financial programs or "advice" shows. If you learn to use them early in your career you will have a much higher chance for success.

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