Trading Tip: Trade with a Plan – Using a Stop Loss
In my opinion, every trade you consider should be laid out ahead of time with a roadmap. A complete map should have an “off ramp” or a place where it makes sense to enter the market. It should also have exits for your destination (profits) as well as off ramps for emergency exits. This part of your plan will likely include stop orders.
Stop orders placed to potentially close an open position are called stop loss orders
A stop order is a contingency order. It is triggered only comes into play at the price level specified in the order. In other words if the market never trades at that price, the order will never become active. The caveat to this is the fact that the market can sometimes gap through your price, at which point the order would be executed at the best possible price. This unfortunately has the tendency to open up the trade to the possibility of getting filled at a far worse price than the one specified in the stop order. So, in summary, a stop loss order specifies a price level at a point and beyond where your order will be triggered to a market order.
Stop loss orders are like big signals where you will pull out of trade
Based on how they function, stop orders have very specific placements. Buy stop orders are placed above the current market price. Sell stop orders are placed below the current market price.
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They work when the market trades at or through the specified stop price level. Once the price is hit, it becomes a market order and is executed at the best price available. Here is an example of a stop loss for an open long position (one that was initiated by buying a contract):
Sell one December e-mini S&P futures contract at 1335.00 stop.
The mechanics of this trade would work in a straightforward way. It would have to be placed below the price level the market is trading at so for this example, assume the market is trading at 1338.00. Normally, I recommend placing a stop loss order 3 points or less from the current market price. So if a long market position was initiated at 1338.00, this stop was placed. If the market starts to trade lower and hits 1335.00, then the sell stop would be triggered and the order would be filled as a sell at the market.
If the market price gaps lower, say 1330.00, the stop loss would still be triggered and the order would be executed at the best possible price. That might mean any price at or below the 1330.00 point. You can see how the gap is something to be aware of.
The same concept applies to a buy stop order. Consider the same example as a buy stop.
Buy one December e-mini S&P futures at 1335.00 stop.
The order would have to be placed above current market price, so keeping with the idea of 3 points or less, assume the market is trading at 1332.00. If the market trades higher, against your open short position (a trade initiated by selling a contract), the order would be triggered once it touches or moves higher than 1335.00.
Traders can use a stop loss order and trail it behind an open position as the market moves in their favor
Stop loss orders don’t go away if the market is moving in your favor. You can trail them to keep them within 3 points or less of the price level the market is trading at. In this way, you can actually try to use your stop loss to protect unrealized profits on an open trade. As long as the position does not get closed by getting filled on your limit order (Secret #2), you could keep rolling or trailing the stop loss order. Additionally, if you close out your position in a way other than through your stop order, don't forget to cancel your stop.
In this way, stop loss orders remain a key component of any trading plan. They are like a safety net, and they can help you try to keep emotion out of your trade. Knowing when to cut your losses and exit a trade can help traders keep things in perspective. Too often people can fall into a trap of holding an open trade that is moving against them, hoping that the market will turn back in their favor. Making a roadmap and sticking to it can help you avoid this pitfall.
President & Founder- Trading Advantage