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Stop Loss Orders

Stop loss orders ("stops") are limits set by traders at which they will automatically enter or exit trades - an order to buy or sell is placed in the market if price reaches a specified limit.

The first discipline that any trader should master is to always limit your losses.

A stop loss order is set to limit a trader's potential loss. The stop loss is placed below the current price (to protect a long position) or above the current price (to protect a short position).

      Example: If you purchase 1,000 IBM at $90.00 you may decide to place a stop loss as follows:
                      SELL 1,000 IBM IF price is less than or equal to $87.00
                      If price falls to $87.00 your order will be activated.
                      Your loss is limited to $3.00 per share (plus brokerage).

stop loss diagram

As a rule: avoid markets with low liquidity where extreme price fluctuations are possible.

Stop Loss Order Types

  • Market Stop Orders
    This is a conventional stop loss order - the stop activates a market order to sell (or buy) at the prevailing market price.
  • Limit Stop Orders
    The limit stop activates an order to sell at the prevailing market price but not below a specified limit (or buy at the prevailing price up to a specified limit).
  • Fixed Price Stop Orders
    The stop loss activates an order at a fixed price. Some exchanges refer to these as limit stop orders so check that you are using the correct stop loss order.

Limit stop orders are recommended for entering a trade: they have a greater chance of success than fixed price orders but are not as open-ended as market orders (where your order will be executed no matter what the market price is).

Market stop orders should be used to exit trades: to ensure that the order has the best possible chance of execution. Never hold on to securities if price falls sharply - in the hope that they will recover. Edwin Lefevre sums up the predicament in Reminiscences of a Stock Operator :

It was the same with all. They would not take a small loss at first but had held on, in the hope of a recovery that would "let them out even." And prices had sunk and sunk until the loss was so great it seemed only proper to hold on, if need be a year, for sooner or later prices must come back. But the break "shook them out," and prices just went so much lower because so many people had to sell, whether they would or not.

Evaluation of Stop Losses

Stop loss orders do not always work perfectly. If a major support level is breached, a large number of stops may be activated at the same time. Sellers will far exceed buyers, causing price to fall sharply and leaving sell orders unfilled. In extreme cases there may be no buyers at all for a security -- not at any price.

Imperfect as they are, stops are still an effective mechanism for limiting risk and protecting capital.

If stops are not accepted in a market, set your own limits and place buy or sell orders when the price is reached. Use SMS alerts if they are available from an online broker. Self-discipline is required to execute stops without hesitation.

Steps Required

  1. First, determine your maximum acceptable loss;
  2. Set stop loss order levels based on sound technical levels;
  3. Adjust your stop loss levels over time to lock in profits;
  4. Use trailing stops to time your entry and exit from the market.


 
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