In this blog series, we have been laying a foundational understanding of the stock market so anyone can open and walk through the door to the world of trading. We want to remove the unknown barrier of fear as you discover the ins and outs of trading and investing. One of the best ways to assuage your fears is by controlling the risk you face when entering a trade or an open position. Simply put, you can minimize your exposure to risk by using stops.
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 which states if the stock on my open trade hits a predetermined dollar amount, exit the trade, and close my position. When the price points hits your dollar amount, a market order is issued 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 than 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 dollar ($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, by using a two dollars margin, it 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 points 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 off of a dollar amount or a percentage. If the stock turns and hits your stop market, it will automatically exit you out of the trade and protects you from greater loss.
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 trader smarter, not harder.