How the “Stop” Can Make You Rich
Every trader wants to make massive gains on every trade they make. We’ve all heard the clichéd advice of buy low and sell high. Of course, every trader wants to make money. Otherwise why do it? But sometimes losing money on a trade can be the smartest thing you have ever done. What do I mean? Let’s talk about limiting losses with the much maligned stop loss.
Traditionally, a stop loss or a “stop” is a special kind of sell order that authorizes your broker to sell your stock when it falls to a certain price that you choose. A stop loss is designed, as the name implies, to stop losses or to lock in profits. The stop price you choose for your trade should be decided upon before you even purchase your stock. Holding to this discipline can allow you to calmly choose an exit price without emotion being involved. Fear and greed have turned many a successful trade into a painful loss. Limit your pain! While you will lose on some trades the stop loss lets you manage your losses and keeps you in the game. Winning stock picks have a tendency to run and will take care of themselves. Use stops to keep the losers under control!
There are a few different types of stops including the “stop order” which basically turns your order into a “market order” after your stock hits the price you have chosen. Meaning your stock will be sold at the best available market price which can be your stop order price or lower. The stop order is probably the most widely used stop loss.
Another kind of stop loss is the “stop limit” where your order basically becomes a “limit order” after your stock falls to the price you have indicated. A stop limit order says you will sell your stock after it falls to a certain price but that you will not accept any less than that price. For instance, if you have a stop limit order on your stock of 22 and the price of the stock falls to 21 before your order can be executed then your stock will not sell. Your stock must first trade at the limit price to activate your stop then there must be another buyer willing to pay the limit price before your stock will sell. Sometimes if the market is falling fast or you are trading a thinly traded stock the market price can go through a stop limit order without your stock being sold.
Yet another type of stop order is the “trailing stop” where a stop price is set at a fixed percentage below the market price. If the market price of your stock increases the stop price increases too, but if the stock price falls the stop loss price remains the same. The “trailing stop” order is designed to let the price of a stock go up indefinitely and close the position when the price falls a set amount, hopefully, protecting your profit. Trailing stops are rapidly increasing in popularity and may someday be standard at all brokers. Ask your broker if trailing stops are available to you as they can be a great tool for protecting your profit!
The last stop order type we will discuss is the most simple of all. Yet, this stop requires you to be incredibly thoughtful, mature, and to possess great discipline. And to be able to monitor your stock position throughout the day. I call this stop order the “mental stop,” or “head stop” and it is used often by great traders and investors. Simply put, you have a stop loss in your mind as the maximum amount you are willing to lose and when your stock hits that price you sell. You don’t pause to think about it, you don’t hope or pray that the stock rallies. You simply sell the stock, take the loss, or profit if there is any left, and you move on. Perhaps you re-enter the same stock at a lower price or perhaps you move on to another position. But if a trade goes bad, and everyone has trades that go bad, the great traders get out! Holding on to a loser stock can ruin your trading portfolio for months if not the whole year.
As William O’Neil, a very successful trader and the founder of Investor’s Business Daily, once said, “My philosophy is that all stocks are bad. There are no good stocks unless they go up in price. If they go down instead, you have to cut your losses fast…Letting losses run is the most serious mistake made by most investors.” So cut those trading losses all ready! And remember whether you use a stop order, a stop limit, a trailing stop, or the simple but hard to use mental stop, losing a little to protect your stock trading profits can add up to big time riches.