Perhaps the single most important risk management order type is the stop loss order. Also known simply as a stop order. When you enter a position in the stock market you should always have a plan on how you are going to exit that position. A stop loss order is the perfect fit for this purpose. In this stock market tutorial we will explain how to effectively use these orders.
Stop orders are designed to do just what the name implies… limit your possible losses. The basic premise of the order is to sell a stock (assuming your opening position was a purchase) if the price of the stock drops to a certain level. Using this order type will allow you to set a maximum loss for any trade you make right after you have purchased the stock. Let’s look at an example.
Let’s say you were keen on the prospects of XYZ stock and purchased 100 shares at a price of $38.25. You predict that the price will rise above $40 in the near future. Of course not every trade goes according to plan so you want to limit your losses if this one goes against you. Let’s say you were willing to lose up to $200 on the trade as a worst case scenario. You would enter your stop loss order at $36.25 immediately after you purchased the shares. Make sure you write the order as a “good until cancel” order (this allows the order to stay active until you cancel it). If the worst happens and the stock plunges down under your stop price, you would exit the position. You would be out $200 plus commissions, but you would be moving on to your next trade.
One of the most common reasons people lose money in the stock market is holding onto bad trades for way too long. Using stop orders is a great way to prevent that from happening. If things don’t go the way you were expecting, get out of the trade and move on. Be sure to read other stock tutorials about all of the different order types that are available to traders.