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Why Use Stop
Orders?
Most
traders and investors don't use Stop Orders, but is this wise?
Stop Orders can help an investor increase their returns,
stem their losses, and reinforce the mechanical aspects of
their trading strategy rather than being pulled around by
their emotions. The logic behind the use of Stop Orders is
simple: cut your losses to preserve your capital. Investors
often overlook the fact that if the value of their investment
declines it takes a greater increase to return their account
balance to where it started. A small loss requires a slightly
larger gain to be even again, but a large loss requires a
Herculean increase just to get back to even. Most investors
kill their chances of great returns by not stemming their
losses. They're just fighting to get back to where they started.
A 10% decline requires an 11% gain to get back to the same
level, and a 15% decline requires a 17% gain. A 20% decline
requires a fairly large 25% gain to just get back to even,
and if an investor lets an investment slip 25% then they need
a 33% gain to get back to where they started. Most investors
are looking for a nice two or three digit return on their
investments, not just an account with the same starting balance.
There are three primary types of Stop Orders: brokerage firms
offer two and one resides in the trader's head. A standard
Stop Order is placed below a purchase price and is triggered
when a stock declines to the specified stop level. A standard
Stop Order becomes a market order when triggered, and will
be executed at the prevailing market price with there being
no guarantee of the price received. Stop Limit Orders turn
into a Limit Order when the stop level is reached. With the
Stop Limit Order the minimum execution price is known but
in fast trending markets the prevailing price may be below
the selected limit price and the sale may not get executed.
The third type of Stop Order is the one manually calculated
by the investor when they enter the position. The secret is
to actually act on the mental stop when the price is reached.
Wealthy traders will use their stop of choice, limit their
losses, and move their capital into a more productive stock.
We wish we could recommend which stop
is appropriate to use, but there are a lot of factors that
go into that decision. The best strategy is to note at
what price you'll be down 10% on a stock, and if that price
is hit, give your representative a call to get an updated
opinion on the stock.
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