How A Stop Order Can Protect You On Losing Trades
An example that would involve a stop order: a trader bought a stock for $50 to see what would happen. If the stock is falling slowly, the market order may execute at $48.40, slightly lower, or even slightly higher (in theory —although this doesn’t happen too often.) If it’s falling quickly, it could execute a little below $48.40. If the stock is falling extremely fast, it could execute well below $48.40.
This is one reason some people avoid using a stop order: They don’t like the possibility that they could set their stop order far below the trigger price. Although this does have the potential to happen, what’s the alternative? Would you rather keep holding the position while it goes even lower? Besides, in most cases your stop order will stop out quite near your trigger price.
The one exception to the rule of having a stop order in place at all times is that you should never leave a stop order in place overnight. The reason is the opening gaps up and down. If the position gaps down, this volatility can needlessly cause your stop order to be filled as much as 20 percent below the price where the position will eventually stabilize that day.
In addition to fearing a bad execution price, some people are afraid that the position will start to go back up immediately after their stop sell order’s been executed. Setting a stop order under support levels will help avoid this problem. A stock may still occasionally bounce right at the point where you set your stop order, just as a random occurrence, but the smart trader weighs this occasional frustration against all the times he’ll save much more money by using a stop order to get out of losing positions. Think of it as the cost of insurance. Using a stop order as insurance will occasionally cost you a little, but it will save you many times more in the long run.
A stop order can limit your risk of loss on bad trades. Put another way, a stop order can enforce the important discipline of taking small losses and getting out when stocks go against you. Some traders find that they are unwilling to take a loss on any stock. They don’t want to admit that they were wrong.
But staying in a bad trade and letting it lose you money is unwise. What often separates a good trader from a bad one is the ability to take small losses. Your goal must be to take small losses and make big gains. If you do this diligently, you’ll become a profitable trader. But, you ask, what if you set your stop order on a stock you still want to trade? The answer’s simple: You can always buy it back later, most likely at a better price, if the trade still has potential.
Many traders don’t want to bother setting a stop order, or are afraid they’ll stop out of a great trade. Also, many traders are unsure of where - how tightly - to set a stop order. It’s true that setting a stop order is an imprecise science and involves lots of trial and error, but in this it’s no different from buying insurance for your property or your health.
