Today I am going to discuss the technique stop loss order. Placing Stop loss orders may seem like a simple thing but is a very important part of a good overall trading plan, no matter whether we are trading stocks, ETFs, Options, or Forex. New traders may ask, “What is a stop-loss order?” A stop-loss order is an order placed with the broker to exit a trade (either buy or sell, depending on whether we are long or short) once the price has hit a certain price level. For example, if you enter an order to buy a stock at $50 and place a stop-loss order at $48, the trade will be closed out once the price hits the $48 level.
One of the advantages of using a stop loss order is that you don’t have to worry about the risk in the trade. There is not a hard and fast rule about where to set your stop loss orders. In the past, we have discussed ‘risk management’, which is really the science of understanding, quantifying and controlling our risk to a certain fixed percentage of your overall account. The initial stop is the key to limiting our initial risk in any one trade. If we trade without that initial hard stop loss order, we leave ourselves completely exposed to market risk. So it is critical to our long-term success that we ALWAYS use an initial stop.
When we look at trading, there are always tradeoffs or advantages and disadvantages to our actions. Another advantage to placing the stop loss order is that you don’t have to watch the trade constantly or, what I refer to as, “baby sitting” the trade as the stop loss order will automatically exit the trade.
Now, on the other hand, a disadvantage to placing the stop loss order is that you may get “stopped out” of the trade if the stop loss order is placed too close to the market price when the order is filled. If we do not allow enough room or space for the stock to move in its regular fluctuations, then we may get stopped out prematurely. This is referred to as putting our stop loss orders too tight for the regular movements in the market. So a good rule of thumb would be to look at the Average True Range, or ATR for short, to look at the normal fluctuations in the market of any particular stock or ETF. For example, if the ATR on a daily chart were, say, 5%, then it would be unwise to place the stop any tighter or closer to the market than that 5% or you are “begging” to get stopped out. The other thing to understand and keep in mind is that when the stop loss level is hit, the stop then becomes a market order and will then be filled at market, not necessarily at the exact price of the stop loss. So in volatile market conditions the loss may be larger than we originally calculated. However, this risk is well worth it as opposed to the alternative of not having a stop loss order in and leaving yourself overly exposed to large market risk.
The bottom line is to ALWAYS place your stop loss order to limit your risk, but not place it so close to the market to not allow for normal market fluctuations so we give the trade a change to succeed.