Welcome to part five of our blog series: A Trader's Journey, where we are covering the first tier of the Foundations of Trading class program. Today's blog will cover the teachings in class 5, and if you wish to review our previous blogs regarding this class, please click on the Foundations of Trading blog category on the right-hand side of the page. That will instantly bring up all the blogs from this series for you to read. As for today's topic, we will cover using stops to minimize your exposure to financial risk.
A stop order is a conditionally based order which is designed to protect your capital by exiting your position if a trade moves against you. It is a simple order that states if the stock on my open trade hits a predetermined dollar amount, exit the trade, and close my position. A market order is issued when the price point hits your dollar amount and your open position is closed. Usually, a stop order will trigger a market order when your stock hits a certain price. It will be the fastest to fill and exit you out of a trade. However, as with all market orders, the price point at which it executes might be different from what you requested.
For example, you purchase ten shares of Disney, DIS, for one hundred dollars ($100.00) a share. Disney trades up to one hundred ten dollars ($110.00) a share. You believe Disney will continue to trade up, but to be on the safe side, you want to lock in some of the profit you have already acquired, so you set a stop order for one hundred eight dollars a ($108.00) share. That way, if the trade turns the other way and the stock drops in price, you have still locked in a profit of eight dollars a share. Also, using a two dollars margin gives the stock room to move without exiting you from the trade too early.
As with a market order, a stop-limit order will exit you out of a trade when your stock hits a prearranged price. You can decide ahead of time the exact price point you want; however, your order may not be filled due to price slippage. When the price point hits your dollar amount, a limit order is issued, and your open position is closed. Your requested price is guaranteed; however, finding someone to fulfill the other side of the trade is not always guaranteed. So, the order can remain open as the stock turns against you.
A trailing stop is designed to lock in profits while giving the stock room for growth. As the stock increases in price, a trailing stop can adjust itself accordingly based on a dollar amount or a percentage. If the stock turns and hits your stop market, it will automatically exit you from the trade and protect you from greater loss.
There are two general tips to remember when it comes to placing your stop. A stop should be placed beyond a historical pivot point, and you should make sure to place a stock when your directional bias changes on your trade. However, the main general rule around Tradesmart is to avoid letting winning trades turn into losing trades. You can do this by moving your stop up as a trade progresses in your favor, so you lock in your profit.
Seriously not using a stop is one of the worse things you can do as a trader. However, there are other bad ideas to avoid, like moving your stop after a trade turns against you, so you are not stopped out of the trade. Remember, lock in your profits, even if you only profit a dollar a share because that is better than losing a dollar a share just because you want to be correct. Also, avoid placing a very tight stop in an effort to balance out the uncertainty of your trade setup or in an attempt to avoid losing money. The negative behaviors can keep you from using stops effectively, so do your best to start using stops early in your trading journey, so they become as second nature as breathing.
Regardless of the type of stop you use, all three of them will help you lock in any profits which have been generated on a current trade, and they are excellent tools to use when you want to walk away from your trades and enjoy the rest of your day. One of the best ways to trade smarter, not harder.
Finally, if you are looking to start your stock trading journey, then follow this link to purchase the recordings of the live Foundations of Trading classes which you can review as many times as you would like. Plus, after you purchase, join us on our discord server to answer any questions you may have. Thank you!