Setting Stop Limit Loss - Your Trading Safety Net

Provided By Ultimate Trading Systems

The Reasons For Using A Stop Limit Loss Order

The markets will not keep your money safe. Though this is a well-known fact, many people find it quite hard to understand. They believe that, no matter what, the market and "good stocks" will "always come back," as though this were a law.

But there's no such law. Stocks don't always come back, and neither do markets. If you want to think about the market in terms of laws of nature, the best one is the law of gravity, specifically: "What goes up must come down." This is especially true for stocks and sectors that have risen extremely quickly. You can protect your capital, and your profits from this ‘natural’ market law by setting stop limit loss.

A stop limit loss is an order you place to sell or buy a position you own if it hits a specified price. It's called stop limit loss because it stops you from losing any more money on the position. If you've sold short, you can place a stop order to buy to cover if the stock rises to a specified price. Stop limit loss is not complicated to use, and they are an integral part of trading success.

When we use the word "stop," we’re referring to a stop limit loss order. This is an order that directs your broker to sell a position you hold if the stock drops to a specified price. If you've sold short, you can place a stop limit loss buy-to-cover order to get out of the position if it rises to a specified price. Once the stop is triggered, it's immediately executed as a market order.

Here's an example. Let's say you buy a stock at $50 a share. You have reason to think it will rise, but you also realize it's a risky trade. You know that if the stock drops below $48.50, it means there's trouble with the trade and you'll want out. So, after buying the stock, you place another order: a stop sell order at $48.40.

This tells the broker that if there is market action at $48.40, or below, to sell your shares immediately in the form of a market order. They'll be sold at the current bid, whatever that is. This will happen automatically, so you won't have to watch the stock closely. It also means you won't be tempted to hold on longer, hoping that the stock will go back up.

A stop limit loss order is an order to sell a position at a specific price and no lower than that price, if the stock drops to that price. Or to buy to cover a stock sold short at a specific price and no higher than that price if it rises to that price. Once the stop limit loss is triggered, the order is executed only if it can be executed at the limit price or better, it becomes a limit order.

Let's say the stock from the earlier example does drop. It hits $48.40, and the stop limit loss is triggered. The stop limit loss order becomes a market order to sell. This means that it will execute immediately at the current bid price. The same principles apply to stops on short positions. If you sell a stock short at $13, expecting it to go down, you should place a buy-to-cover order at, say, $13.75. If the stock suddenly rises sharply, you're protected - and you can always re-short the stock at its peak price later.

Let's go back to the stock the trader bought for $50. If the stock is falling slowly, the market order may execute at $48.40, slightly lower, or even, occasionally, slightly higher. If it's falling quickly, it could execute a little below $48.40. If the stock is falling very quickly, it could execute well below $48.40.

The possibility that they could be stopped out of a position far below the trigger price is one reason traders may avoid using stop limit loss. Although this could happen, it’s better than the alternative, to keep holding the position while it goes even lower. Besides, in most cases the position will be stopped out quite near the trigger price. 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 limit loss has been executed.

A stock may occasionally bounce right at the point where you set your stop limit loss, as a random occurrence. But the smart trader weighs this rare frustration against all the times he’ll save much more money by using stop limit loss to get out of losing positions. Think of it as the cost of insurance. Using stop limit loss as insurance will occasionally cost you a little, but it will save you many times more in the long run, and you don’t often get a chance to insure against a law of nature.

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