Stop Order & Limit Stop Orders - Tools to Manage Your Stock Trading Risk

Stop orders and limit stop orders are tools you can use when buying or selling stock to trigger a buy or sell order once the stock reaches a specified price.

Reducing Stock Trading Risk

No matter how smart you think you are or how successful you’ve been when it comes to trading stocks, you need to protect yourself from experiencing huge losses.  Stock trading can be a risky business and you’re not going to execute a profitable trade every single time.  The safest and easiest way to reduce your potential losses when trading stocks is by placing a “stop” or “stop limit” order.

Using Stop Loss Orders

Since I am normally in front of my trading monitors whenever I enter a trade, I rarely place a stop unless I decide to step away from my trading desk.  If the trading action slows and I make the decision to step away from my trading desk I will then place a basic stop, which protects me in case the share price moves lower.

Stop Order Example

Let’s say you purchase 200 shares of XYZ for $10 a share, and after entering the trade you decide to take a break where you’ll be away from your computer.  This is a scenario where you must place a stop order. It’s up to each individual to make the decision on how much the stop price should be, but this can be easily figured out based on what amount you’re willing to lose if the trade goes against you. 

If you own 200 shares at $10 a share and the maximum amount you are willing to lose is $200, then your stop order would be placed at $9.  Once your stop order is placed it puts the odds in your favor that if the share price drops to exactly $9 your shares will be sold.  This will limit your losses in case the share price continues to drop further.

Better Safe than Sorry

You might think that using a stop when trading stocks seems a little extreme, especially if you plan to only be away from your computer for a few seconds.  I can tell you from experience that those quick trips to the kitchen for a cup of coffee can become quite expensive if you don’t use a stop order.  If you’re new to online trading, or trading in general, the safest approach would be to place a stop every time you enter a trade.

Stop Limit Order

If you’re unable to watch the trading action for the entire day, or you intend on holding your shares for a longer period of time, it’s best to place a “stop limit” order.  A stop limit order is similar to a basic stop order, but with the additional protection of a limit order. 

Let’s say you’re holding XYZ stock currently at $15.00 a share. To protect yourself from downside risk, you enter a stop price of $14.50 and a Limit Price of $14.25.  With this set up, if the stock falls below your stop order of $14.50, a limit order will be placed to sell the stock at a price no lower than $14.25. However, if due to high volatility the stock falls below the $14.25 limit price, you will retain your position and the order will remain open as a standard limit order until it has expired.

I have been in trades where I placed a stop, stepped away from my computer, came back to see the share price well below my stop order, yet I still owned several shares.  This was due to a lack of shares being traded and an increase in volatility.  It’s rare when a situation like that occurs and using stops isn’t a 100% guarantee that you wont acquire larger losses, but placing stops when trading stocks should always be used.

Stop Orders and Stock Profits

Finally, some good news.  Using stops is not only a trading tool that should be used to limit losses, they should also be used for locking in profits.  If those 200 shares of XYZ you purchased for $10 a share increases to $11 then place a stop at 10.50 to lock in a gain.  You can adjust the amount of shares you include in the stop order, in case you want to hold some remaining shares as a longer term investment.  I always enter a trade with one thing in mind.  Profit.

I would rather place a stop to lock in some profit than to hold for a bigger gain, only to watch the share price drop below my original entry price.  This usually results in the trade turning into a loss, or you end up holding it for an extended period of time hoping it bounces back to your original entry spot.  Trading stocks is about making money.  Limit your losses by using stops and use them to consistently lock in profits.

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